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janetse0429QUALIFICATION PROGRAMME VOLUME 1
Professional Module 11
nal
Financial
1
Reporting
SECOND EDITION
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FINANCIAL REPORTING
MODULE 11
FINANCIAL REPORTING
Qualification Programme
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Second edition 2023
ISBN 9781394158904
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Published by
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The content of this work is for educational purposes and standards and regulations should be referred to as definitive
information sources. The fact that an organization, website, or product is referred to in this work as a citation and/or
potential source of further information does not mean that the publisher and authors endorse the information or
services the organization, website, or product may provide or recommendations it may make. This work is sold with the
understanding that the publisher is not engaged in rendering professional services. The advice and strategies contained
herein may not be suitable for your situation. You should consult with a specialist where appropriate. Further, readers
should be aware that websites listed in this work may have changed or disappeared between when this work was written
and when it is read. Neither the publisher nor authors shall be liable for any loss of profit or any other commercial damages,
including but not limited to special, incidental, consequential, or other damages.
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 John Wiley and Sons, Inc.
2023
ii
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T a b le of C ontents
TABLE OF CONTENTS
Module 11: Financial Reporting
Director’s Message vi
Introductionvii
HKICPA Proficiency Levels and Taxonomy viii
Learning Outcomes xi
Study Text Key Features xxiv
VOLUME 1
PART A FINANCIAL REPORTING FRAMEWORK IN HONG KONG 1
CHAPTER 1: Financial Reporting Framework in Hong Kong
and the Related Implications for Business Activities 3
CHAPTER 2: Financial Reporting Framework and Standard
for Small and Medium-Sized Entities, and
Financial Reporting Standard for Other Private
Entities in Hong Kong 53
PART B CONCEPT OF ETHICS WHERE IT IS APPROPRIATE TO
ADOPT ETHICAL STANCES FOR PROFESSIONAL
ACCOUNTANTS IN BUSINESS 103
CHAPTER 3: Code of Ethics for Professional Accountants 105
PART C: APPROPRIATE ACCOUNTING PRINCIPLES AND
CONCEPTS TO ACCOUNT FOR BUSINESS TRANSACTIONS 133
CHAPTER 4: Fair Value Measurement 135
CHAPTER 5: Revenue 179
CHAPTER 6: Inventories 269
CHAPTER 7: Property, Plant and Equipment 297
CHAPTER 8: Investment Property 361
iii
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FINANCIAL REPORTING
CHAPTER 9: Leases 417
CHAPTER 10: Borrowing Costs 505
CHAPTER 11: Intangible Assets 527
CHAPTER 12: Financial Assets, Financial Liabilities and
Equity Instruments 579
CHAPTER 13: Hedge Accounting 675
CHAPTER 14: Impairment of Assets 727
CHAPTER 15: Non-current Assets Held for Sale and
Discontinued Operations 833
CHAPTER 16: Accounting Policies, Changes in Accounting
Estimates and Errors 875
CHAPTER 17: Events after the Reporting Period 929
CHAPTER 18: Provisions, Contingent Liabilities and
Contingent Assets 955
VOLUME 2
CHAPTER 19: Income Taxes 1015
CHAPTER 20: Earnings per Share 1085
CHAPTER 21: Related Party Disclosures 1131
CHAPTER 22: Government Grants 1157
CHAPTER 23: Employee Benefits 1185
CHAPTER 24: Share-based Payments 1235
CHAPTER 25: Operating Segments 1311
CHAPTER 26: Other Business Transactions, including
Agriculture and Biological Assets, Insurance
Contracts, Mineral Resources and Service
Concession Arrangements 1341
CHAPTER 27: Financial Statements for an Individual Entity 1393
iv
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T a b le of C ontents
PART D GROUP FINANCIAL STATEMENTS WITH
COMPLEX GROUP STRUCTURES 1445
CHAPTER 28: Interim Financial Reporting 1447
CHAPTER 29: Business Combinations 1481
CHAPTER 30: Consolidated Financial Statements with
a Simple Group Structure 1557
CHAPTER 31: Foreign Exchange and Consolidation
of Foreign Operations 1641
CHAPTER 32: Investments in Associates 1713
CHAPTER 33: Joint Arrangements 1775
CHAPTER 34: Consolidated Financial Statements with
Complex Group Structure 1817
CHAPTER 35: Merger Accounting for Common Control
Combinations 1871
PART E CURRENT ISSUES AND DEVELOPMENTS
IN FINANCIAL REPORTING 1893
CHAPTER 36: Integrated Reporting/Sustainability Reporting 1895
Glossary of Terms 1923
Index 1935
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FINANCIAL REPORTING
D I R E C T O R ’ S M E SS A G E
Congratulations on choosing the Qualification Programme (‘QP’) of the Hong Kong Institute of
Certified Public Accountants (‘HKICPA’) as your pathway to becoming a CPA! You have joined
thousands of others on this exciting and important journey to develop the knowledge, skills
and perspectives you need to succeed in your career and becoming a valued member of the
Institute.
The world is evolving rapidly, so too is the business environment. The Accounting
profession faces a number of challenges and trends including technological enhancement,
regulatory development, changing societal expectations and more.
Professional accountants are no longer left only to deal with numbers, but also to analyse
and advise. We are also expected to be highly strategic, collaborative, and building trust by
demonstrating relevance and value to many aspects of society.
The QP of the HKICPA aims at qualifying accountants with the agility needed to embrace the
changing environment. You will grow and discover a plethora of relevant competencies through
QP by completing training programmes, passing professional examinations and acquiring
practical experience under an authorised employer or supervisor. In the longer term, we hope
that you will succeed not only in accountancy but also in enhancing your employability and
portability so that you will be able to help business and society move forward.
We are delighted to partner with you on your development journey.
The QP consists of three levels of designations:
• The Associate Level aims to build a solid foundation of technical accounting knowledge.
• The Professional Level aims to deepen your technical capabilities and develop core
enabling competences in the workplace.
• The Capstone integrates your knowledge, skills and experiences to resolve business
problems and emerge as a top tier accounting professional.
We have designed this Learning Pack to provide you with the valuable resources for your
development on attaining your CPA designation under the QP. I trust you will be successful and
enjoy your QP journey!
Should you require any assistance at any time, please feel free to contact us on (852) 2287 7228.
Kit Wong
Director of Education and Training
Hong Kong Institute of Certified Public Accountants
vi
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INT R O D U CT ION
INTRODUCTION
Successfully preparing for a career in accounting is a significant undertaking. To better prepare
you for this challenging profession, the Hong Kong Institute of Certified Public Accountants
(HKICPA) provides a qualification programme (QP) comprising three progressive levels: A
10-module Associate Level, a four-module Professional Level including workshops and a
Capstone that includes three-day workshops and a final examination.
The Professional Level of the QP comprises four modules. Each of these modules involves
approximately 120 hours of self-study and an open-book module examination. There are also a
total of five workshops to be completed for the Professional Level. They include a prerequisite
Introductory Workshop and a one-day workshop for each Professional Module.
• Module 11: Financial Reporting
• Module 12: Business Finance
• Module 13: Business Assurance
• Module 14: Taxation
While each of the Associate Level and Professional Level modules stands on its own, the
modules are also arranged in a series of ‘verticals’ that map to the CPA competence blueprint.
These verticals are designed to develop an area of knowledge, through two or three modules,
from basic understanding to professional excellence.
The Financial Accounting and Reporting vertical runs from Module 1, through Module 6 to
Professional Level Module 11: Financial Reporting. A second vertical, Management Accounting,
runs from Module 2, via Module 7 to Professional Level Module 12: Business Finance. The
third vertical, Audit and Assurance, develops from Module 8 to Professional Level Module 13:
Business Assurance. The fourth vertical, Taxation, takes students from Module 9 to Professional
Level Module 14: Taxation.
Each Professional Level module of the new QP requires students to sit a three-hour
examination. Two exam sittings are held each year in June session and December session.
Please refer to the Student Handbook for the examination structure and the cut-off rule on
the examinable content.
vii
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FINANCIAL REPORTING
HKICPA PROFICIENCY LEVELS AND TAXONOMY
The proficiency level indicated in the table below reflects the level at which the topics covered
in particular learning outcome is tested. There are three levels of proficiency:
• Level 1 is the foundational level, covering the skills of knowledge and comprehension.
• Level 2 is the intermediate level, covering the skills of application and analysis.
• Level 3 is the advanced level, covering the skills of integration and evaluation.
You are expected to understand which skill is exercised based on the taxonomy verbs with
which it is associated.
Please note that the list of taxonomy verbs below is for reference only and does not
represent an exhaustive list.
LEVEL 1: FOUNDATION
Skill Verb Definition
Knowledge Define Give the accepted meaning of
The remembering of previously Identify List or ascertaining possibilities before
learned material (recall of facts) analysis; Point to the essential part or
parts
List Provide a concise summary of the
relevant points, often in bullet point
format
Outline Give the main facts about something
State Accurately articulate established
principles, concepts, terms etc.
Comprehension Describe Communicate the key features of
Demonstrative understanding something, present a detailed account
of facts and ideas by organising, of something focusing on depth of
comparing, translating, knowledge
interpreting, giving descriptions Explain Make clear the details of something;
and stating main ideas or show how the reason for, or
underlying cause of, or the means by
which something occurs
Illustrate Offer examples, to show how something
happens, that something happens,
or make concrete a concept by giving
examples
Interpret Make clear the meaning of something
and its implications
Summarise Describe something concisely; bring
together the main facts
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H K IC P A P R O F IC IENC Y L EV EL S A ND T A X ONOM Y
LEVEL 2: INTERMEDIATE
Skill Verb Definition
Application Account for / Demonstrate Give details of accounting entries to
Using new knowledge. Solve be made for in the context of financial
problems to new situations by reporting or justify (if used in a more
applying acquired knowledge, general context); Demonstrate the
facts, techniques and rules in a accounting treatment by using a set of
different way accounts
Apply Demonstrate knowledge, concepts or
techniques; Use established methods /
tools / procedures to resolve relatively
straightforward scenarios or problems
Calculate / Compute Determine by computation or arrive at
by mathematical means or processes
Prepare Follow established procedures /
methods to create a report of financial
information or commentary (e.g. using a
proforma spreadsheet)
Solve To work out to a result or conclusion
Use Apply in a practical way
Analysis Analyse To examine methodically by
Examine and break information separating into parts and studying the
into parts by identifying motives interrelationships in order to discover
or causes. Make inferences essential features
and find evidence to support Compare Critically consider two or more things,
generalisation emphasising their similarities
Contrast Critically consider two or more things,
emphasising their differences
Classify / Categorise Apply concepts to categorise
information or groups into categories
Justify Explain the reason for recommendation
made, or underlying cause of, based
on an analysis of a range of available
options
Prioritise / Determine Determine the order for dealing with
a series of items or tasks according to
their relative importance e.g. Determine
the priorities / determine the level of
importance
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FINANCIAL REPORTING
LEVEL 3: ADVANCED
Skill Verb Definition
Integration Construct To form an idea, a process, or procedure
Compile information together by bringing together various theoretical
in a different way by combining and conceptual elements
elements in a new pattern or Design Develop a procedure/process or course
proposing alternative solutions of action based on selection of the
Design optimum combination from a range of
available options
Develop To bring something into existence that
has not previously existed, or to reshape
something from its initial position into
something more refined; Use judgement
to bring to a more advanced or effective
state or to create a plan
Formulate Devise and put a plan into words
Integrate Combine one aspect of learning with
another to form a holistic understanding of
a process, procedure or course of action
Plan / Propose Formulate a detailed proposal for doing
or achieving something
Produce Draw together similar or disparate items
to form a report containing financial
and/or non-financial information
Evaluation Advise Communicate appropriately the
The ability to judge the value recommended course of action based
of material for a given purpose on an analysis of specific circumstances
in a manner suited to the recipient
Appraise Assess the value or quality of something;
or to assess its performance
Consider Think carefully about something before
making a decision, to look closely or
attentively at something through a
process involving critical thinking
Evaluate Assess and determine the value,
importance or qualities of something,
normally with reference to specific
criteria and draw conclusions
Recommend Select the best course of action or
choice; Advocate a particular outcome or
course of action based on an analysis of
a range of available options
References
Anderson, L. W., Krathwohl, D. R., Airiasian, W., Cruikshank, K. A., Mayer, R. E., & Pintrich, P. R. (2001).
A taxonomy for learning, teaching and assessing: A revision of Bloom’s Taxonomy of educational outcomes:
Complete edition. New York: Longman.
The International Federation of Accountants. (2016). Framework for International Education Standards for
Professional Accountants and Aspiring Professional Accountants. (2015). Retrieved from https://www.ifac.org
The Government of the Hong Kong Special Administrative Region. (2016). Qualification Framework – Generic
Level Descriptors. Retrieved from https://www.hkqf.gov.hk
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L EA R NING O U T COM ES
LEARNING OUTCOMES
Each module includes Principal Learning Outcomes and Supporting Learning Outcomes
arranged along a series of proficiency levels.
Module 11:
Syllabus area Weighting (%)
Explain and apply the financial reporting framework in Hong Kong 5–10
Apply appropriate accounting principles and concepts to account for business 10–25
transactions
Evaluate and advise on appropriate accounting principles to account for complex 30–45
business transactions
Prepare, present and appraise group financial statements with complex group 25–35
structures
Describe the current issues and developments in financial reporting 2–5
Describe and apply the concept of ethics where it is appropriate to adopt ethical 5–10
stances for professional accountants in business
The syllabus weighting table indicates the relative weightings of the syllabus areas encompassed
in this module. It serves as a guide to the percentage of study time spent on each syllabus area. In
the long run, the marks allocation in the module examinations would conform to the weightings as
shown above. The exact range of marks allocation in each module examination may deviate from
the weightings for suitably robust questions to be set.
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FINANCIAL REPORTING
Learning Outcomes Proficiency Chapter
Level where
covered
PRINCIPAL LO1: EXPLAIN AND APPLY THE FINANCIAL REPORTING FRAMEWORK IN HONG KONG
LO1.01: D
escribe and explain the financial reporting framework 1
in Hong Kong and the related implications for business
activities
1.01.01 Explain the importance and setting of accounting standards 1 1
1.01.02 Describe the role of the: 1 1
• HKICPA;
• Securities and Futures Commission (SFC);
• Accounting and Financial Reporting Council (AFRC);
• Hong Kong Insurance Authority (HKIA);
• Hong Kong Monetary Authority (HKMA); and
• Hong Kong Stock Exchange (HKEx)
1.01.03 Describe how Hong Kong Financial Reporting Standards are set 1 1
1.01.04 E
xplain the condition under which an entity may adopt the 1 2
Hong Kong Small and Medium-sized Entity Financial Reporting
Framework (SME-FRF) and the Hong Kong Small and Medium-
sized Entity Financial Reporting Standard (SME-FRS)
1.01.05 S
ummarise the requirements of the Hong Kong SME-FRF and 1 2
the Hong Kong SME-FRS
1.01.06 E
xplain the conditions under which an entity may adopt the 1 2
HKFRS for Private Entities
1.01.07 Summarise the requirements of the HKFRS for Private Entities 1 2
1.01.08 D
escribe the status of Hong Kong (IFRIC) Interpretations, 1 1
Hong Kong Interpretations (HK-Int) and Hong Kong (SIC)
Interpretations
1.01.09 Identify other professional pronouncements and exposure 1 1
drafts relevant to the financial reporting conceptual framework
1.01.10 Identify relevant regulatory bodies and their impact on 1 1
accounting
1.01.11 E
xplain what is meant by a conceptual framework and 1 1
generally accepted accounting principles
1.01.12 Illustrate the advantages and disadvantages of a conceptual 1 1
framework
1.01.13 S
ummarise the components and requirements of the HKICPA’s 1 1
Conceptual Framework
1.01.14 E
xplain those requirements of HKAS 1 Presentation of Financial 1 1
Statements which overlap with the HKICPA’s Conceptual
Framework
PRINCIPAL LO2: APPLY APPROPRIATE ACCOUNTING PRINCIPLES AND CONCEPTS TO ACCOUNT FOR
BUSINESS TRANSACTIONS
Describe and account for business transactions in accordance with
Hong Kong Financial Reporting Standards as they relate to:
LO2.01: Government grants 2
2.01.01 Define government grants 1 22
2.01.02 A
ccount for government grants (including government loan at 2 22
a below-market rate of interest)
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L EA R NING O U T COM ES
Learning Outcomes Proficiency Chapter
Level where
covered
2.01.03 Explain the recognition criteria for government grants 1 22
2.01.04 E
xplain and describe the different presentation methods 1 22
available for government grants related to assets
2.01.05 E
xplain and describe the different presentation methods 1 22
available for government grants related to income
2.01.06 Prepare disclosure in respect of government grants 2 22
LO2.02: Employee benefits 2
2.02.01 Define employee benefits 1 23
2.02.02 A
pply the recognition and measurement principles in respect 2 23
of employee benefits, including termination benefits
2.02.03 Account for defined contribution plans 2 23
2.02.04 Account for defined benefit plans 2 23
2.02.05 E
xplain the difference between defined contribution plans and 1 23
defined benefit plans
2.02.06 Prepare disclosure in respect of employee benefits 2 23
LO2.03: Share-based payments 2
2.03.01 Account for share-based payment transactions 2 24
2.03.02 A
ccount for equity-settled and cash-settled share-based 2 24
payment transactions
2.03.03 A
ccount for share-based payment transactions with cash 2 24
alternatives
2.03.04 A
ccount for unidentified goods or services in a share-based 2 24
payment transaction
2.03.05 A
ccount for share-based payment transactions among group 2 24
entities
2.03.06 Prepare disclosure in respect of share options 2 24
LO2.04: Borrowing costs 2
2.04.01 Explain the expenses which constitute borrowing costs 1 10
2.04.02 Explain borrowing costs that eligible for capitalisation 1 10
2.04.03 Explain the assets which are qualifying assets 1 10
2.04.04 E
xplain when the capitalisation of borrowing costs shall 1 10
commence, be suspended and cease
2.04.05 C
alculate the amount of borrowing costs in respect of specific 2 10
borrowing and general borrowing to be capitalised
2.04.06 P
repare journal entries for borrowing costs, including 2 10
expensed and capitalised borrowing costs
2.04.07 Prepare disclosure in respect of borrowing costs 2 10
LO2.05: Financial assets, financial liabilities and equity instruments 2
2.05.01 A
pply the criteria for the recognition and de-recognition of a 2 12
financial asset or financial liability
2.05.02 A
pply the principles for the classification of financial 2 12
assets, financial liabilities and equity instruments, and their
measurement (including compound instruments)
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FINANCIAL REPORTING
Learning Outcomes Proficiency Chapter
Level where
covered
2.05.03 A
ccount for the financial assets, financial liabilities and equity 2 12
instruments
2.05.04 A
pply the appropriate treatment for the impairment of 2 12
financial assets
2.05.05 A
ccount for derivative financial instruments and simple embedded 2 12
derivatives, including the application of own-use exemption
2.05.06 Account for treasury shares 2 12
2.05.07 P
repare disclosure in respect of financial assets, financial 2 12
liabilities and equity instruments
LO2.06: Hedge accounting 2
2.06.01 Explain when a hedge relationship qualifies for hedge accounting 1 13
2.06.02 Identify fair value hedges, cash flow hedges and hedges for net 1 13
investment
2.06.03 A
ccount for fair value hedges, cash flow hedges and hedges for 2 13
net investment
2.06.04 Prepare disclosure in respect of hedging 2 13
LO2.07: Income taxes 2
2.07.01 Account for current tax liabilities 2 19
2.07.02 Account for income tax 2 19
2.07.03 Calculate the carrying amount and tax base 2 19
2.07.04 Calculate deferred tax amounts 2 19
2.07.05 Account for tax losses and tax credits 2 19
2.07.06 E
xplain the initial recognition exemption for deferred tax assets 1 19
and liabilities
2.07.07 A
ccount for deferred tax relating to investments in subsidiaries, 2 29, 30,
associates and joint ventures 32, 33
2.07.08 Illustrate when tax assets and liabilities can be offset 1 19
2.07.09 Prepare disclosure in respect of income taxes 2 19
LO2.08: Effects of changes in foreign exchange rates 2
2.08.01 D
etermine the functional currency of an entity including 2 31
foreign operation
2.08.02 A
ccount for a change in presentation currency and functional 2 31
currency
2.08.03 Account for foreign currency transactions and balances 2 31
2.08.04 Calculate and account for the exchange differences 2 31
2.08.05 P
repare the translation of foreign operation financial 2 31
statements to the presentation currency
2.08.06 Prepare disclosure in respect of foreign exchange 2 31
LO2.09: Related party disclosures 2
2.09.01 Explain the parties that may be related to a business entity 1 21
2.09.02 Explain the importance of identifying related parties 1 21
2.09.03 Prepare disclosure in respect of related party transactions 2 21
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L EA R NING O U T COM ES
Learning Outcomes Proficiency Chapter
Level where
covered
LO2.10: Fair value measurement 2
2.10.01 E
xplain concepts and principles in relation to fair value 1 4
measurement, including definition of fair value, principal
market, most advantageous market and market participants.
2.10.02 D
etermine an appropriate valuation technique in measuring 2 4
the fair value of an asset or a liability item.
2.10.03 D
etermine appropriate inputs to valuation techniques in 2 4
measuring the fair value of an item, with reference to the fair
value hierarchy.
2.10.04 A
pply the valuation approach to measure the fair value for key 2 4
financial and non-financial assets and liabilities.
2.10.05 Prepare disclosures in respect of fair value measurements. 2 4
LO2.11: Earnings per share 2
2.11.01 E
xplain the meaning and significance of a company’s earnings 1 20
per share
2.11.02 C
alculate the earnings per share, including the impact of a 2 20
bonus issue, a rights issue and an issue of shares at full market
value
2.11.03 E
xplain the relevance of a company’s diluted earnings per 1 20
share
2.11.04 Illustrate the limitations of using earnings per share as a 1 20
performance measure
2.11.05 Prepare disclosure in respect of earnings per share 2 20
LO2.12: Operating segments 2
2.12.01 Define operating segments 1 25
2.12.02 E
xplain when operating segments should be aggregated and 1 25
disaggregated
2.12.03 Illustrate the nature of segmental information to be disclosed 1 25
2.12.04 P
repare disclosure in respect of operating segments and 2 25
appropriate entity-wide information
LO2.13: Interim financial reporting 2
2.13.01 E
xplain the circumstances in which interim financial reporting 1 28
is required
2.13.02 E
xplain the purpose and advantages of interim financial 1 28
reporting
2.13.03 A
pply the principles of recognition and measurement in interim 2 28
financial statements
2.13.04 P
repare disclosure in respect of interim financial statements 2 28
including seasonality in the interim financial statements
LO2.14: Agriculture 1
2.14.01 Define biological asset and agricultural produce 1 26
2.14.02 D
escribe the recognition of biological asset and agricultural 1 26
produce
xv
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FINANCIAL REPORTING
Learning Outcomes Proficiency Chapter
Level where
covered
LO2.15: Insurance contracts 1
2.15.01 Define insurance contract 1 26
2.15.02 Describe recognition and measurement of insurance contract 1 26
LO2.16: Exploration for and evaluation of mineral resources 1
2.16.01 Define exploration and evaluation expenditures 1 26
2.16.02 Describe elements of cost of exploration and evaluation assets 1 26
2.16.03 D
escribe measurement of exploration and evaluation assets 1 26
upon initial recognition and subsequent measurement (i.e. cost
model or revaluation model)
2.16.04 Explain presentation of exploration and evaluation assets 1 26
2.16.05 E
xplain when and how to assess impairment of exploration and 1 26
evaluation assets
LO2.17: Service concession arrangements 1
2.17.01 Describe typical features of service concession arrangements 1 26
2.17.02 D
escribe the accounting treatment of operators for public-to- 1 26
private service concession arrangements
PRINCIPAL LO3: EVALUATE AND ADVISE ON APPROPRIATE ACCOUNTING PRINCIPLES TO ACCOUNT
FOR COMPLEX BUSINESS TRANSACTIONS
Account for, evaluate and advise on business transactions in accordance
with Hong Kong Financial Reporting Standards as they relate to:
LO3.01: A
ccounting policies, changes in accounting estimates 3
and errors
3.01.01 C
ontrast and classify accounting policies and accounting 2 16
estimates
3.01.02 E
valuate the financial impacts on a change in accounting policy, 3 16
accounting estimate and prior period error
3.01.03 P
repare and appraise disclosure in respect of changes in 3 16
accounting policies, changes in accounting estimates and
errors
LO3.02: Revenue 3
3.02.01 Apply the core principle of recognition of revenue 2 5
3.02.02 A
pply the criteria for recognising revenue generated from 2 5
contracts where performance obligations are satisfied over time
3.02.03 A
pply the principle to determine the contract costs to be 2 5
recognised
3.02.04 A
pply the measurement principles as they apply to revenue 2 5
and related costs
3.02.05 A
pply the recognition criteria for specified types of revenue items 2 5
3.02.06 A
dvise the appropriateness of the accounting treatments in 3 5
respect of the revenue recognition
3.02.07 P
repare and appraise disclosure in respect of revenue from 3 5
contracts with customers
xvi
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L EA R NING O U T COM ES
Learning Outcomes Proficiency Chapter
Level where
covered
LO3.03: Inventories 3
3.03.01 Describe the scope and definition of inventories 1 6
3.03.02 U
se acceptable methods of assigning costs including the 2 6
allocation of overheads to inventories
3.03.03 Calculate the cost of inventories 2 6
3.03.04 E
valuate the potential impact of net realisable value falling 3 6
below cost and make the required adjustments
3.03.05 A
dvise on the appropriate accounting treatment to be adopted 3 6
in respect of inventories
3.03.06 Analyse variances in a standard costing system 2 6
3.03.07 Prepare and appraise disclosure in respect of inventories 3 6
LO3.04: Property, plant and equipment 3
3.04.01 D
escribe the non-current assets which fall within or outside the 1 7
scope of property, plant and equipment
3.04.02 A
pply the recognition criteria in respect of property, plant and 2 7
equipment
3.04.03 A
ccount for initial measurement of property, plant and 2 7
equipment, including assets acquired by exchange or transfer
3.04.04 A
ccount for subsequent expenditure on property, plant and 2 7
equipment
3.04.05 D
escribe the available methods to measure property, plant and 1 7
equipment subsequent to initial recognition
3.04.06 Account for the revaluation of property, plant and equipment 2 7
3.04.07 Apply an appropriate useful life for an asset 2 7
3.04.08 Identify the separate significant components and calculate the 2 7
depreciation amount in respect of different types of asset
3.04.09 A
ccount for the transfer of properties from or to property, 2 7
plant and equipment
3.04.10 Account for the disposal of property, plant and equipment 2 7
3.04.11 E
valuate the different methods of depreciation: straight line, 3 7
diminishing balance and units of production
3.04.12 Evaluate the cost model and revaluation model 3 7
3.04.13 P
repare and appraise disclosure in respect of property, plant 3 7
and equipment
LO3.05: Intangible assets 3
3.05.01 Describe the scope and definition of an intangible asset 1 11
3.05.02 A
pply the definition of an intangible asset to both internally- 2 11
generated and purchased intangibles
3.05.03 A
ccount for the recognition and measurement of intangible 2 11
assets
xvii
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FINANCIAL REPORTING
Learning Outcomes Proficiency Chapter
Level where
covered
3.05.04 A
ccount for the subsequent accounting treatment of intangible 2 11
assets including amortisation and impairment
3.05.05 C
alculate the amortisation expense for various intangible 2 11
assets
3.05.06 A
dvise on the accounting treatments of expenses incurred 3 11
during research phase and development phase
3.05.07 Analyse how goodwill arises 2 11
3.05.08 E
valuate and account for internally generated goodwill and 3 11
goodwill arising on business combination
3.05.09 A
ccount for internally generated intangible assets and 2 11
intangible assets acquired as part of a business combination
3.05.10 Prepare and appraise disclosure in respect of intangible assets 3 11
LO3.06: Investment property 3
3.06.01 Describe the scope and definition of an investment property 1 8
3.06.02 A
pply the recognition and measurement principles in respect 2 8
of investment property
3.06.03 A
ccount for investment property under cost model and fair 2 8
value model
3.06.04 C
onsider the situation when a property can be transferred in 3 8
and out of the investment property category
3.06.05 E
valuate the impacts on transferring an investment property 3 8
from other categories of property holdings and advise on the
accounting treatments
3.06.06 P
repare and appraise disclosure in respect of investment 3 8
property
LO3.07: Impairment of assets 3
3.07.01 D
escribe assets that are within the scope of impairment of 1 14
assets
3.07.02 D
escribe an asset that may be impaired by reference to 1 14
common external and internal indicators
3.07.03 Describe the cash-generating unit that an asset belongs to 1 14
3.07.04 Explain when an impairment review should be performed 1 14
3.07.05 C
alculate the recoverable amount with reference to value-in- 2 14
use and fair value less cost to sell
3.07.06 C
lassify different levels of impairment test: assets vs cash- 2 14
generating units or group of cash- generating units
3.07.07 A
dvise and calculate the impairment loss, including the loss 3 14
relating to cash-generating units
3.07.08 A
dvise on the allocation of impairment loss and account for 3 14
subsequent reversal
3.07.09 P
repare and appraise disclosure in respect of impairment loss, 3 14
including critical judgement and estimate
xviii
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L EA R NING O U T COM ES
Learning Outcomes Proficiency Chapter
Level where
covered
LO3.08: Leases 3
3.08.01 Appraise whether a contract is, or contains, a lease. 3 9
3.08.02 A
pply the principles regarding the separation of the 2 9
components of a lease contract into lease and non-lease
elements.
3.08.03 Apply the recognition exemptions applicable to lessees. 2 9
3.08.04 A
dvise on the accounting treatments for leases from the 3 9
perspective of the lessee, including the initial and subsequent
measurement of the right-of-use assets and lease liabilities.
3.08.05 A
pply the reassessment of the lease liability, including 2 9
modification of leases.
3.08.06 A
pply the classification rules of leases as operating or finance 2 9
leases from the perspective of the lessor.
3.08.07 A
dvise on the accounting treatments for leases from the 3 9
perspective of the lessor, including both finance and operating
leases.
3.08.08 Evaluate and account for sale and leaseback transactions. 3 9
3.08.09 Prepare and appraise the disclosure in respect of leases. 3 9
LO3.09: Events after the reporting period 3
3.09.01 E
xplain the period during which there is responsibility for 1 17
reporting events
3.09.02 Account for adjusting and non-adjusting events 2 17
3.09.03 E
xplain when the financial statements should be prepared on a 1 17
basis other than going concern
3.09.04 A
dvise on the appropriate accounting adjustments in respect of 3 17
adjusting events
3.09.05 P
repare and appraise disclosure in respect of events after the 3 17
reporting period
LO3.10: Provisions, contingent liabilities and contingent assets 3
3.10.01 Explain provisions, contingent liabilities and contingent assets 1 18
3.10.02 E
valuate the differences between trade payables, accruals and 3 18
provisions
3.10.03 A
pply the criteria for recognition of provisions to specific 2 18
circumstances
3.10.04 A
pply the appropriate accounting treatment for onerous 2 18
contracts
3.10.05 A
pply the appropriate accounting treatment for contingent 2 18
assets and liabilities
3.10.06 A
ccount for decommissioning, restoration and similar liabilities 2 18
and their changes
3.10.07 P
repare and appraise disclosure in respect of provisions, 3 18
contingent liabilities and contingent assets
xix
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FINANCIAL REPORTING
Learning Outcomes Proficiency Chapter
Level where
covered
LO3.11: Non-current assets held for sale and discontinued operations 3
3.11.01 C
lassify non-current assets (or disposal groups) as held for 2 15
sale or as held for distribution to owners and discontinued
operations
3.11.02 Evaluate and consider when a sale is highly probable 3 15
3.11.03 E
xplain what assets are within the measurement provision of 1 15
non-current assets held for sale and discontinued operations
3.11.04 A
pply the principles of measurement to non-current assets 2 15
(or disposal groups) held for sale or distribution to owners
and discontinued operations including initial measurement,
subsequent measurement and change of plan of sale
3.11.05 Account for impairment loss and subsequent reversal 2 15
3.11.06 Account for assets ceased to be classified as held for sale 2 15
3.11.07 P
repare disclosure in respect of non-current assets held for 2 15
sale or distribution to owners and discontinued operations
(including the prior year restatement)
PRINCIPAL LO4: PREPARE, PRESENT AND APPRAISE GROUP FINANCIAL STATEMENTS WITH COMPLEX
GROUP STRUCTURES
LO4.01: C
onstruct the financial statements for an individual entity
in accordance with Hong Kong Financial Reporting Standards
and statutory reporting requirement
4.01.01 C
onstruct the statement of financial position, and the 3 27
statement of profit or loss and other comprehensive income
4.01.02 C
onstruct and explain the contents and purpose of the 3 27
statement of changes in equity
4.01.03 C
onstruct and explain the contents and purpose of the 3 27
statement of cash flows
4.01.04 E
xplain the importance to disclose significant judgement and 1 27
accounting estimates
4.01.05 P
repare and appraise disclosure in respect of accounting policy 3 27
and items required by the Hong Kong Financial Reporting
Standards, New Companies Ordinance and other rules and
regulations
Construct the financial statements for a group in
accordance with Hong Kong Financial Reporting Standards
and statutory reporting requirements for:
LO4.02: Business combinations 3
4.02.01 E
valuate and explain a business combination and the 3 29
difference between acquisition of asset, and of a business
4.02.02 A
nalyse the acquisition date of an acquisition and explain when 2 29
control is obtained to determine the date of acquisition
4.02.03 C
lassify the identifiable assets (including intangibles) and 2 29
liabilities acquired in a business combination
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L EA R NING O U T COM ES
Learning Outcomes Proficiency Chapter
Level where
covered
4.02.04 A
pply the recognition principle to identifiable assets and 2 29
liabilities
4.02.05 Apply measurement basis to identifiable assets and liabilities 2 29
4.02.06 Account for contingent consideration initially and subsequently 2 29
4.02.07 E
xplain how to account for acquisition-related costs, including 1 29
those related to issue of debt or equity securities
4.02.08 D
escribe what is part of the business combination transaction 1 29
and the consideration
4.02.09 Account for measurement period adjustments 2 29
LO4.03: Concepts of control and consolidation 3
4.03.01 Describe the concept of a group as a single economic entity 1 30
4.03.02 A
nalyse what constitutes control and the impact of potential 2 30
voting rights
4.03.03 C
lassify a subsidiary and determine when a group should start 2 30
and stop consolidating a subsidiary
4.03.04 Define investment entity 1 30
4.03.05 Explain the purpose of consolidated financial statements 1 30
4.03.06 E
xplain the importance of uniform accounting policies and 1 30
coterminous year ends in the preparation of consolidated
financial statements
4.03.07 A
ccount for adjustments required to measure differences in 2 30
the length and timing of accounting periods
4.03.08 Account for deferred tax arising from business combination 2 30
4.03.09 E
valuate and apply the appropriate accounting treatment of 3 30
goodwill, including the impairment of goodwill
4.03.10 Explain the importance of eliminating intra-group transactions 1 30
4.03.11 Account for the effects of intra-group trading 2 30
4.03.12 A
ccount for non-controlling interest, including when the 2 30
subsidiary has negative equity balance
4.03.13 Construct a consolidated statement of financial position 3 30
4.03.14 C
onstruct a consolidated statement of profit or loss and other 3 30
comprehensive income
4.03.15 Construct a consolidated statement of change in equity 3 30
4.03.16 Construct a consolidated statement of cash flows 3 30
LO4.04: Foreign subsidiary 2
4.04.01 A
ccount for foreign currency transactions within an individual 2 31
company and in the consolidated financial statements
4.04.02 Account for disposal or partial disposal of a foreign operation 2 31
LO4.05: Investments in associates 3
4.05.01 Describe an associate 1 32
4.05.02 A
nalyse significant influence and apply the principle to classify 2 32
an associate
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FINANCIAL REPORTING
Learning Outcomes Proficiency Chapter
Level where
covered
4.05.03 A
nalyse the reasons for, and impact of, equity accounting, 2 32
including purchase price allocation on initial acquisition, fair
value adjustments, upstream and downstream transactions,
and uniform accounting policies
4.05.04 A
ccount for investors’ share of losses of an associate in excess 2 32
of its investments in associates
4.05.05 E
xplain the impairment test and related treatments for 1 32
investments in associates
4.05.06 Account for the disposal of an associate 2 32
4.05.07 P
repare and appraise the disclosure in respect of investments 3 32
in associates
LO4.06: Joint arrangements 3
4.06.01 Describe joint arrangements 1 33
4.06.02 Define joint control 1 33
4.06.03 Explain and contrast joint operations and joint ventures 2 33
4.06.04 Classify and account for a joint venture and joint operations 2 33
4.06.05 A
ccount for the transactions between a venturer and a joint 2 33
venture
4.06.06 P
repare and appraise disclosure in respect of joint 3 33
arrangements
LO4.07: Changes in ownership 3
4.07.01 C
onsider and account for disposal of ownership interest in a 3 34
subsidiary with and without losing control
4.07.02 C
onsider and account for acquisition of a subsidiary achieved 3 34
in stages
LO4.08: Merger accounting for common control combinations 1
4.08.01 Describe the principles of merger accounting 1 35
4.08.02 Describe the procedures and practices of merger accounting 1 35
4.08.03 Illustrate how merger accounting is applied to a common 1 35
control combination
PRINCIPAL LO5: DESCRIBE THE CURRENT ISSUES AND DEVELOPMENTS IN FINANCIAL REPORTING
LO5.01: D
escribe the impact of current issues and developments in 1
financial reporting
5.01.01 D
escribe the impact of current issues and developments in 1 36
financial reporting both in Hong Kong and internationally
LO5.02: Describe the social responsibilities 1
5.02.01 D
escribe the development of integrated reporting and 1 36
sustainability reporting in Hong Kong
5.02.02 D
escribe the current developments in integrated reporting and 1 36
sustainability reporting
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L EA R NING O U T COM ES
Learning Outcomes Proficiency Chapter
Level where
covered
PRINCIPAL LO6: DESCRIBE AND APPLY THE CONCEPT OF ETHICS WHERE IT IS APPROPRIATE TO ADOPT
ETHICAL STANCES FOR PROFESSIONAL ACCOUNTANTS IN BUSINESS
LO6.01: E
xplain and apply the Code of Ethics for Professional 2
Accountants
6.01.01 D
escribe the fundamental principles and the conceptual 1 3
framework
6.01.02 C
lassify and analyse threats to compliance with the 2 3
fundamental principles
6.01.03 Analyse the effectiveness of available safeguards 2 3
6.01.04 S
olve the conflicts in the application of fundamental principles 2 3
for Professional Accountants in business
6.01.05 E
xplain the requirements of the Code of Ethics for Professional 1 3
Accountants
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FINANCIAL REPORTING
STUDY TEXT KEY FEATURES
Each of the Associate Level and Professional Module texts include a series of pedagogical
features designed to help QP candidates better absorb the material, reach the required
proficiency levels and meet the outlined Learning Outcomes (LOs).
The aim of these features is to help students understand the content while regularly
reinforcing concepts and building the skills necessary to successfully complete each of the
modules and progress through the Associate Level, the Professional Level and the Capstone.
Each chapter includes these features:
• Chapter topic list: A succinct list of the specific topics covered in the chapter.
• Learning outcomes: Outlines the specific knowledge points covered in the chapter and
the specific skills related to each learning outcome (LO) discussed in the chapter.
• Opening case: A case study that aims to relate the material covered in the chapter
to a real-life situation. At times, this opening case may be linked to opening cases in
other chapters.
• Overview: Provides a more detailed preview of the material covered in the chapter.
• Exhibits and charts: Through illustrations and examples, exhibits and charts aim to
convey information in graphic fashion or actual examples of accounting, reporting or
calculations that are likely to be used in actual practice.
• Illustrative examples: Case studies that explore specific issues related to the chapter
topics and further understanding of the LOs.
• Apply and analyse: Exam questions with analysis provided to show how to approach
answering the question and apply what was learned from the concepts presented in
the chapter.
• Ethics in practice: Ethical discussions on issues that may arise during professional practice.
• Key learning point: A concise summary of a salient point that is key to achieving
chapter LOs.
• Knowledge check questions: A set of questions geared at furthering students
understanding of specific topics, work through problems and meet the chapter LOs.
• Summary: A list of the concepts and topics covered in the chapter in an easy-to-
review format.
• Mind map: A graphic depiction of the knowledge conveyed in the chapter to facilitate
understanding of the LOs.
• Exam practice questions: Questions similar to those likely to be featured in the
examination paper required for each QP module.
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Part A
Financial Reporting
Framework in Hong Kong
Chapter 1 Financial Reporting Framework in Hong Kong and the Related
Implications for Business Activities
Chapter 2 inancial Reporting Framework and Standard for Small and
F
Medium-Sized Entities, and Financial Reporting Standard for
Other Private Entities in Hong Kong
1
1
Financial Reporting
Framework in Hong Kong
and the Related Implications
for Business Activities
CHAPTER TOPIC LIST
1.1 Role of Regulatory Authorities in 1.2.3 Other Professional
Financial Reporting Pronouncements and
1.1.1 Role of the Hong Kong Exposure Drafts
Institute of Certified Public 1.2.4 Standard-setting Process
Accounting (HKICPA) 1.3 Conceptual Framework for
1.1.2 Role of the Accounting Financial Reporting
and Financial Reporting 1.3.1 Purpose, Status and Scope
Council (AFRC) 1.3.2 The Objective of General
1.1.3 Role of the Stock Exchange of Purpose Financial Reporting
Hong Kong Limited (HKEx) 1.3.3 Qualitative Characteristics of
1.1.4 Role of the Securities and Useful Financial Information
Futures Commission (SFC) 1.3.4 Going Concern Assumption
1.1.5 Role of the Hong Kong 1.3.5 Reporting Entity
Insurance Authority (HKIA) 1.3.6 Elements of Financial Statements
1.1.6 Role of the Hong Kong 1.3.7 Recognition and Derecognition
Monetary Authority (HKMA) of the Elements of Financial
1.2 Hong Kong Financial Reporting Statements
Standards Overview 1.3.8 Measurement of the Elements
1.2.1 Financial Reporting Standards of Financial Statements
1.2.2 Interpretations
3
FINANCIAL REPORTING
1.3.9 Concepts of Capital and Capital 1.4.2 Recognition and Measurement
Maintenance 1.4.3 Presentation and Disclosure
1.3.10 Conceptual Framework and 1.5 Current Developments
HKAS 1 (Revised) Presentation 1.5.1 Primary Financial
of Financial Statements Statements Project
1.4 First-time Adoption of HKFRS 1.5.2 Disclosure Initiative
1.4.1 Overview 1.5.3 Management Commentary
4
F I N AN CI AL R E P O R TI N G F R A M EW O R K IN H O NG K O NG A ND T H E R EL A T ED IM P L IC AT IONS
LEARNING OUTCOMES
PRINCIPAL LO1: EXPLAIN AND APPLY THE FINANCIAL REPORTING FRAMEWORK IN HONG KONG
LO1.01: Describe and explain the financial reporting framework in Hong Kong and the related
implications for business activities
1.01.01 Explain the importance and setting of accounting standards
1.01.02 Describe the role of:
• HKICPA;
• Securities and Futures Commission (SFC);
• Accounting and Financial Reporting Council (AFRC);
• Hong Kong Insurance Authority (HKIA);
• Hong Kong Monetary Authority (HKMA); and
• Hong Kong Stock Exchange (HKEx)
1.01.03 Describe how Hong Kong Financial Reporting Standards are set
1.01.08 Describe the status of Hong Kong (IFRIC) Interpretations, Hong Kong Interpretations (HK-Int)
and Hong Kong (SIC) Interpretations
1.01.09 Identify other professional pronouncements and exposure drafts relevant to the financial
reporting conceptual framework
1.01.10 Identify relevant regulatory bodies and their impact on accounting
1.01.11 Explain what is meant by a conceptual framework and generally accepted accounting
principles
1.01.12 Illustrate the advantages and disadvantages of a conceptual framework
1.01.13 Summarise the components and requirements of the HKICPA’s Conceptual Framework
1.01.14 Explain those requirements of HKAS 1(Revised) Presentation of Financial Statements which
overlap with the HKICPA’s Conceptual Framework
5
FINANCIAL REPORTING
OPENING CASE
SUPER STAR
S uper Star Financial Limited (Super Star), incorporated in Japan, is principally engaged in
the provision of financial services, including securities brokerage and asset management
services in Japan. To tap into China’s booming financial market, Super Star set up a holding
company in Hong Kong and relocated its headquarters from Japan to Hong Kong.
Super Star is licensed under the Securities and Futures Ordinance to conduct securities
dealing and asset management businesses in Hong Kong from 1 January 2018.
In addition to operating a finance business, Super Star extended its business to property
investment in Hong Kong. Super Star purchased a commercial building in Central (Building A)
for leasing purposes in October 2018.
Before setting up a holding company in Hong Kong, Super Star prepared its financial
statements using Japanese generally accepted accounting principles (Japanese GAAP). Kris
Leung, the CFO of Super Star as well as a member of HKICPA, is currently preparing the first
financial statements reported under HKFRSs for the year ended 31 December 2018.
6
F I N AN CI AL R E P O R TI N G F R A M EW O R K IN H O NG K O NG A ND T H E R EL A T ED IM P L IC AT IONS
OVERVIEW
Financial reporting standards are a set of accounting standards that govern how particular
types of transactions and events should be reported in financial statements.
The growing of cross-border transactions increases the need for a set of financial reporting
standards that can be applied on a globally consistent basis to provide investors and other
users of financial statements with the ability to compare the financial performance of publicly
listed companies on a like-for-like basis with their international peers. The International
Financial Reporting Standards (IFRS) are widely accepted as a set of high-quality and
transparent global standards intended to achieve consistency and comparability. In 2001,
the Council of the HKICPA adopted a policy to develop the Hong Kong Financial Reporting
Standards (HKFRS) that converged with the IFRS issued by the International Accounting
Standards Board (IASB). Currently, more than 100 countries have converged with the IFRS or
are in the process of doing so.
The HKFRSs are developed based on the Conceptual Framework that is comprised of a
set of interrelated concepts based on the decision-making needs of the users of financial
statements.
The full benefits of a global set of financial reporting standards will be realised only
when these standards are consistently enforced. Institutions, such as the HKICPA, banking
and insurance supervisory authorities, stock exchanges and capital market authorities play
important roles in enforcing financial reporting requirements in Hong Kong.
1 . 1 ROLE OF REGULATORY AUTHORITIES
IN FINANCIAL REPORTING
This section provides a summary of the role of different regulatory bodies, which play an
important role in developing and enforcing financial reporting requirements.
1.1.1 Role of the Hong Kong Institute of Certified Public
Accounting (HKICPA)
The HKICPA is the standard-setter responsible for the development, maintenance and
enhancement of accounting, auditing and professional ethical standards in Hong Kong. This
statutory body was set up under the Professional Accountants Ordinance (Chapter 50) in 1973
and is responsible for regulation of the accountancy profession in Hong Kong.
7
FINANCIAL REPORTING
Apart from setting standards (see Section 1.1.6), the HKICPA is empowered to:
• Set admission and continuing registration criteria for its members;
• Oversee the quality of auditing practices and monitor compliance with relevant
standards by its members; and
• Conduct investigations and exercise disciplinary powers over its members.
To enhance independence of the regulatory regime, the Financial Reporting Council
(Amendment) Ordinance (known as the Amendment Ordinance) was enacted on 30 January
2019, which transferred the responsibility for regulating auditors of a public interest entity
(PIE) from the HKICPA to the Financial Reporting Council (FRC).
The management of HKICPA is vested in its Council, which is predominantly comprised of
accounting and auditing professionals elected from within its membership and representations
appointed by the government.
The HKICPA expects its members who assume responsibility for the preparation or audit
of financial statements to observe the HKFRSs. Where apparent failures are brought to the
attention of the Council, it may investigate and take appropriate action.
1.1.2 Role of the Accounting and Financial Reporting Council (AFRC)
The Accounting and Financial Reporting Council (AFRC) was established by the Government in
May 2022, replacing the Financial Reporting Council (FRC). A number of transitional steps are to
be implemented over the rest of 2022.
The AFRC is intended to be an independent body which, among other roles, will take over
the function of issuing practising certificates for CPAs, the registration of accounting practice
units and local Public Interest Entities auditors, and the inspection, investigation and discipline
of the accounting profession. The AFRC will oversee the HKICPA’s performance of its various
professional functions.
These are important changes which will need the AFRC and HKICPA to work in a
coordinated way.
1.1.3 Role of the Stock Exchange of Hong Kong Limited (HKEx)
The HKEx is a private organisation but has been given the privilege by the government to
operate and maintain the stock market in Hong Kong. Through its Listing Division, the HKEx
administers the Listing Rules and undertakes periodic reviews to ensure the maintenance of
acceptable standards in the marketplace.
Currently, two established exchanges exist under the HKEx: the Main Board and GEM, on
which companies are listed in Hong Kong.
8
F I N AN CI AL R E P O R TI N G F R A M EW O R K IN H O NG K O NG A ND T H E R EL A T ED IM P L IC AT IONS
Companies listed on the Main Board are required to comply with the Main Board Listing
Rules; companies listed on GEM are required to comply with GEM Rules. These rules specify
disclosures to be provided in the financial statements.
1.1.3.1 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 four
months after the end of the financial year. For interim reports, the reporting obligation must be
sent within three months after the end of that period of six months.
A listed company needs to comply with the minimum disclosure requirements as specified
in Appendix 16 of the Listing Rules. Specific requirements are set out for announcements of
results, interim reports, annual reports, listing documents and circulars in relation to equity
securities.
For all types of financial statements, the Listing Rules requires the disclosures of the
following basic financial information:
• Statement of profit or loss and other comprehensive income;
• Statement of financial position; and
• Notes relating to revenue, taxation, earning per share, dividends and any other notes
the directors consider necessary for a reasonable appreciation of the results for the
financial period.
For annual reporting, additional financial information is required by the Listing Rules,
including:
• Particulars of every subsidiary;
• Details of convertible or redeemable financial instruments issued;
• Information about purchase of own shares;
• Analysis of the maturity profile of borrowings;
• Analysis of directors’ remuneration by emolument bands and information in respect of
the five highest paid individuals during the financial year;
• Credit policy and aged analysis of accounts receivable; and aged analysis of
accounts payable;
• Details of pension scheme;
• Valuation of properties or other tangible assets; and
• Five-year summary of the published results and of the assets and liabilities of
the group.
GEM Rules
Companies listed on the GEM are subject to tighter reporting requirements. For example, they
are required to publish annual and interim reports (including quarterly reports) within three
months and 45 days, respectively, after the end of each relevant financial period.
The disclosure requirements for annual reporting under the GEM Rules (Chapter 18) are
in many ways similar to the Listing Rules though there are some specific disclosures, which
9
FINANCIAL REPORTING
are only applicable under the GEM Rules. For example, companies listed on GEM are required
to provide a comparison of business progress with business objectives stated in the listing
documents during at least the first two full financial years after listing.
The HKEx routinely reviews the interim and annual reports of listed entities and makes
enquiries from such entities of any breach of the disclosure requirements of the Listing Rules
or the GEM Rules as appropriate and any apparent failures to observe accounting standards
and guidelines.
Listed entities are required to state which accounting body’s generally accepted accounting
principles (GAAP) and standards have been followed in the preparation of their financial
statements. Listed entities are permitted to adopt the IFRS and the Chinese Accounting
Standards for Business Enterprises (CASBE) instead of the HKFRSs. Those that choose the IFRS
and CASBE are required to explain any significant differences with the HKFRSs, including a
reconciliation of the financial effect on net profit or loss.
Illustrative Example 1
Entity A is a listed company, and it entered into a Purchase Agreement with Entity B to
purchase a commercial building for a consideration of HK$731 million. Such acquisition
constitutes a substantial acquisition for Entity A under the Listing Rules. Entity A
is required to publish an announcement and a circular including relevant financial
information (e.g. financial effects of the acquisition and property valuation report) in
accordance with the Listing Rules.
1.1.4 Role of the Securities and Futures Commission (SFC)
The Securities and Futures Commission (SFC) is an independent non-governmental statutory
body and was established pursuant to the enactment of the Securities and Futures Commission
Ordinance in 1989, which later consolidated with other securities and futures-related
ordinances to become the Securities and Futures Ordinance. It is the primary regulatory body
for the securities and futures markets in Hong Kong.
The SFC’s objective is to promote fair, efficient and orderly securities and futures markets in
Hong Kong. Through its Corporate Finance Division, the SFC oversees the performance of the
HKEx’s role as the frontline regulator of listing matters. All the amendments and additions of
the Listing Rules require ultimate approval of the SFC.
Under the Securities and Futures Ordinance (Cap.571), the SFC is empowered to set the
regulatory requirements for intermediaries (including brokers, investment advisors and fund
managers) regarding, among other things, financial resources, client money, client securities,
audit and accounts, and record keeping.
Persons who are responsible for the preparation or audit of financial statements relating
to corporations that are licensed under the Securities and Futures Ordinance are expected to
observe specific rules and disclosure requirements as promulgated by the SFC.
10
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1.1.5 Role of the Hong Kong Insurance Authority (HKIA)
The Hong Kong Insurance Agency (HKIA) is an insurance regulator independent of the
government and the insurance industry. In accordance with the Insurance Ordinance (Cap.41),
the principal function of the IA is to regulate and supervise the insurance industry for the
promotion of the general stability of the insurance industry and for the protection of existing
and potential policyholders.
The Insurance Ordinance is the principal legislation to regulate the insurance industry in
Hong Kong. The regulatory framework is applicable to insurers and insurance intermediaries.
Going into effect on 23 September 2019, the IA will take over regulation of insurance
intermediaries (i.e. insurance agents and brokers) from the three existing self-regulatory
organisations (the Hong Kong Confederation of Insurance Brokers, the Professional Insurance
Brokers Association and Insurance Agents Registration Board) and administer a new statutory
licensing regime.
The Insurance Ordinance sets out the requirements for the financial and other reporting
obligations of insurers and insurance intermediaries, including submission of audit accounts
and information about capital and net assets and financial insolvency, etc.
1.1.6 Role of the Hong Kong Monetary Authority (HKMA)
The Hong Kong Monetary Authority (HKMA) is the bank regulator and is an integral part of
the Hong Kong SAR Government. It is responsible for authorising, supervising and regulating
banking business in Hong Kong, with its mandate and powers established by the Banking
Ordinance (Cap.155).
The Banking Ordinance provides the legal framework for banking supervision in Hong
Kong. The principal function of the HKMA under the Banking Ordinance is to promote the
general stability and effective functioning of the banking system. In performing this function,
the HKMA generally seeks to align Hong Kong’s banking regime with international standards,
including implementing the recommendations of the Basel committee on Banking Supervision,
of which Hong Kong has been a member since 2009.
To satisfy the requirements of the Banking Ordinance, apart from submitting audited
accounts to the HKMA, banks are required to report periodically about their compliance of
capital and liquidity requirements as set out in the Banking Ordinance.
1 . 2 HONG KONG FINANCIAL REPORTING
STANDARDS OVERVIEW
Generally accepted accounting principles (GAAP) often refers to a common set of accepted
accounting principles and standards that companies must follow when they compile their
financial statements. In Hong Kong, there are mandatory and advisory sources of GAAP.
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FINANCIAL REPORTING
Those sources that are mandatory include:
• Companies Ordinance (Cap.622): The basic requirement to prepare annual financial
statements is to set out in the Companies Ordinance, which requires financial
statements to give a true and fair view of the company (or group’s) financial position
and performance. The Companies Ordinance provides statutory backing to the HKFRSs
issued by the HKICPA.
• HKFRS: As defined in HKAS 1 (Revised) Presentation of Financial Statements, the
term ‘HKFRS’ includes all HKFRS, Hong Kong Accounting Standards (HKAS), and
Interpretations issued by the HKICPA.
• Listing rules: The rules governing the listing of companies on the Main Board and GEM
of the HKEx.
Those sources that are advisory in nature include:
• HKICPA Accounting Guidelines;
• HKICPA Accounting Bulletins; and
• HKICPA Conceptual Framework or most recent pronouncements of other standard-setting
HKAS 8.10 bodies that use a similar conceptual framework to develop accounting standards.
For the purpose of this chapter, 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 Interpretations approved by the Council of the
HKICPA and currently in issue unless otherwise specified.
1.2.1 Financial Reporting Standards
Financial reporting standards provide principles for preparing financial statements. HKFRSs are
the principal source of Hong Kong GAAP. Compliance with the HKFRS is presumed to result in
HKAS 1.15 financial statements that achieve a true and fair view.
The HKFRSs are designed to apply to general purpose financial statements and other
financial reporting of profit-oriented entities. Although the HKFRSs are not designed to apply
to not-for-profit activities in the private sector, public sector or government, entities with such
activities may find them appropriate.
The HKFRSs set out recognition, measurement, presentation and disclosure requirements
dealing with transactions and events that are important to the decision-making needs of the
users of general purpose financial statements.
Since 1993, the HKICPA has laid down the policy to model Hong Kong accounting standards
on international standards. Going into effect on 1 January 2005, the HKFRSs were fully
converged with the IFRS issued by the IASB. From then on, the HKICPA adopts the IFRS word for
word as HKFRSs.
The international standards on which Hong Kong standards are based follow a
principles-based approach as opposed to the rules-based approach adopted in the United
States. Principles-based approach emphases on applying standards in a way that gives useful
information to readers of financial statements.
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Exhibit 1.1 shows a list of Hong Kong Accounting Standards in issue as of 31 May 2022.
HKAS 1 (Revised) Presentation of Financial Statements
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 12 Income Taxes
HKAS 16 Property, Plant and Equipment
HKAS 19 (2011) Employee Benefits
HKAS 20 Accounting for Government Grants and Disclosure of Government Assistance
HKAS 21 The Effects of Changes in Foreign Exchange Rates
HKAS 23 (Revised) Borrowing Cost
HKAS 24 (Revised) Related Party Disclosures
a
HKAS 26 Accounting and Reporting by Retirement Benefit Plans
HKAS 27 (2011) Separate Financial Statements
HKAS 28 (2011) Investments in Associates and Joint Ventures
a
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
HKAS 40 Investment Property
HKAS 41 Agriculture
HKFRS 1 (Revised) First-time Adoption of Hong Kong Financial Reporting Standards
HKFRS 2 Share-based Payment
HKFRS 3 (Revised) Business Combinations
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 (2019) 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 14a Regulatory Deferral Accounts
HKFRS 15 Revenue from Contracts with Customers
HKFRS 16 Leases
HKFRS 17 Insurance Contracts
a
Not examinable.
EXHIBIT 1.1 Hong Kong accounting standards
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FINANCIAL REPORTING
The HKFRSs are heavily shaped by IFRS developments, and closely monitor developments in
financial reporting standards issued by the IASB.
1.2.1.1 Timing of Application of HKFRS
HKFRSs should be applied from a date specified in the document. New or revised HKFRSs set
out transitional provisions to be applied on their initial application.
Illustrative Example 2
Entity A has a financial year ended 31 March 2018. If a new or revised accounting
standard or interpretation becomes effective for annual financial periods beginning
on or after 1 January 2018, that means that new or revised accounting standard or
interpretation becomes effective for the first financial year that begins on or after
1 January 2018. In the case of Entity A that has a 31 March year-end, such an accounting
standard or interpretation would, therefore, be applied initially for the financial year that
commences on 1 April 2018.
1.2.1.2 Financial Reporting Framework for small- and medium-sized Entities
Certain smaller companies or groups meeting the necessary requirements and size criteria
are permitted (but not required) to adopt the HKFRS for Private Entities or the HKICPA’s locally
developed small and medium-sized financial reporting framework and financial reporting
standards. More details are covered in Chapter 2.
1.2.2 Interpretations
One of the consequences of principles-based financial reporting standards is that principles
can be open to interpretation. To address queries and difficulties raised in the implementation
of financial reporting standards in practice, interpretations were issued by HKICPA to
give authoritative guidance on issues that are likely to receive divergent or unacceptable
treatment in the absence of such guidance. Some of those interpretations were adopted from
interpretations issued by IASB; others are developed by HKICPA locally on matter of local
interest. Both types of interpretations have the same authoritative status, that is, they are part
of HKFRSs.
Interpretations should be applied to current and future reporting periods from the date of
issue or other specified effective date. Transitional provisions that apply on initial application of
an interpretation are specified in the interpretation.
1.2.2.1 Hong Kong (IFRIC) [HK(IFRIC)] Interpretations
Hong Kong [HK(IFRIC)] Interpretations are interpretations adopted from interpretations
issued by the IFRS Interpretations Committee (the Committee), the interpretative body
of the IASB.
Exhibit 1.2 shows a list of HK (IFRIC) Interpretations in issue as at 31 May 2022.
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HK(IFRIC)-Int 1 Changes in Existing Decommissioning, Restoration and Similar Liabilities
HK(IFRIC)-Int 2 Members’ Shares in Co-operative Entities and Similar Instruments
HK(IFRIC)-Int 5 Rights to Interests arising from Decommissioning, Restoration and Environmental
Rehabilitation Funds
HK(IFRIC)-Int 6 Liabilities arising from Participating in a Specific Market–waste Electrical and
Electronic Equipment
HK(IFRIC)-Int 7 Applying the Restatement Approach under HKAS 29 Financial Reporting in
Hyperinflationary Economics
HK(IFRIC)-Int 10 Interim Financial Reporting and Impairment
HK(IFRIC)-Int 12 Service Concession Arrangements
HK(IFRIC)-Int 14 HKAS 19 – The Limit on a Defined Benefit Asset, Minimum Funding Requirements
and their Interaction
HK(IFRIC)-Int 16 Hedges of a Net Investment in a Foreign Operation
HK(IFRIC)-Int 17 Distributions of Non-cash Assets to Owners
HK(IFRIC)-Int 19 Extinguishing Financial Liabilities with Equity Instruments
HK(IFRIC)-Int 20 Stripping Costs in the Production Phase of a Surface Mine
HK(IFRIC)-Int 21 Levies
HK(IFRIC)-Int 22 Foreign Currency Transactions and Advance Consideration
HK(IFRIC)-Int 23 Uncertainty over Income Tax Treatments
EXHIBIT 1.2 HK(IFRIC) interpretations
Interpretations must not change or conflict with HKFRSs or the Conceptual Framework
(covered in Section 1.3). An interpretation includes:
• A summary of the accounting issues identified;
• The agreement reached on the appropriate accounting;
• References to relevant HKFRSs, parts of the Conceptual Framework and other
pronouncements that have been drawn upon to support the agreement; and
• The effective date and transition provisions.
Some of the enquiries received from stakeholder will result in the issuance of an
interpretation. In some cases, the IFRS IC may decide not to recommend standard-setting. This
might be because the IFRS IC concludes that the existing standards or interpretations provide
enough information for a company to determine its accounting or because no evidence shows
a widespread accounting problem exists. The IFRS IC publishes an agenda decision to explain
why it did not recommend standard-setting.
Agenda decisions often include information to help companies applying the IFRS. They do
so by explaining how the applicable principles and requirements in the Standards apply to the
question submitted by stakeholders.
1.2.2.2 Hong Kong (SIC) Interpretations
Similar to Hong Kong (IFRIC) Interpretations, HK (SIC) Interpretations correspond to an IASB
interpretation. The only difference is that Hong Kong (SIC) Interpretations are adopted from
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FINANCIAL REPORTING
interpretations issued by the Standard Interpretations Committee (SIC), the predecessor of the
IFRS Interpretations Committee.
Exhibit 1.3 shows a list of HK (SIC) Interpretations in issue as at 31 May 2022.
HK(SIC)-Int 10 Government Assistance – No specific Relation to Operating Activities
HK(SIC)-Int 25 Income Taxes – Changes in the Tax Status of an Enterprise or its Shareholders
HK(SIC)-Int 29 Service Concession Arrangements: Disclosures
HK(SIC)-Int 32 Intangible Assets – Web Site Costs
EXHIBIT 1.3 Hong Kong (SIC) interpretations
1.2.2.3 Hong Kong Interpretations
Hong Kong Interpretations (HK Interpretations) refers to interpretations that the HKICPA
developed locally. These are guidance or requirements on matters of particular concern to
Hong Kong but not covered by the IFRS. Such interpretations help achieve consistency of
application, particularly where in the past an industry practice has developed, which did not
have a strong basis in the standards.
Exhibit 1.4 shows a list of HK Interpretations in issue as at 31 May 2022.
HK-Int5 (2020) Presentation of Financial Statements – Classification by the Borrower of a Term Loan that
Contains a Repayment on Demand Clause
EXHIBIT 1.4 Hong Kong interpretations
1.2.3 Other Professional Pronouncements and Exposure Drafts
1.2.3.1 Accounting Guidelines (AGs)
Accounting Guidelines (AGs) issued by the HKICPA act as guidance treatments and indicators
of best practice. Unlike the HKFRSs, AGs are not mandatory for members of the HKICPA but
are consistent with the purposes of HKFRSs in that they help define accounting practice in
particular areas. Accordingly, they are expected to be followed, and HKICPA members may be
called upon to explain departures with which they have been involved.
Exhibit 1.5 shows a list of AGs in issue as at 31 May 2020.
AG 1 Preparation and Presentation of Accounts from Incomplete Records
AG 5 (Revised) Merger Accounting for Common Control Combinations
AG 7 Preparation of Pro Forma Financial Information for Inclusion in Investment Circulars
EXHIBIT 1.5 Accounting guidelines
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1.2.3.2 Accounting Bulletins (ABs)
Accounting Bulletins (Abs) are informative publications issued by the HKICPA on subjects of
topical interest, which are intended to assist members of the HKICPA or to stimulate debate on
important financial reporting issues, including application issues on financial reporting arising
from the Hong Kong Companies Ordinance. ABs do not require the approval of the Council of
the HKICPA and do not have the same authority as either HKFRSs or AGs.
Exhibit 1.6 shows a list of ABs in issue as at 31 May 2022.
AB 3 (Revised) Guidance on Disclosure of Directors’ Remuneration
AB 4 Guidance on the Determination of Realised Profits and Losses in the Context of
Distributions under the Hong Kong Companies Ordinance
AB 5 Guidance for the Preparation of a Business Review under the Hong Kong Companies
Ordinance Cap.622
AB 6 Guidance on the Requirements of Section 436 of the Hong Kong Companies Ordinance
Cap.622
EXHIBIT 1.6 Accounting bulletins
1.2.3.3 Exposure Drafts
Exposure Drafts and Draft Interpretations represent a proposed Standard/Interpretation, which
are issued by the HKICPA in advance of the issue of the final Standards/Interpretations. The
HKICPA invites individuals and organisations to provide comments expressing agreement or
disagreement on any matter(s) in the proposed draft.
Although substantial alterations may be made in the light of comments received,
these Exposure Drafts and Draft Interpretations are a useful indicator of the eventual
requirements.
Until the effective date of a HKFRS, the requirements of any HKFRS that would be affected
by proposals in an exposure draft remain in force.
1.2.4 Standard-setting Process
The HKICPA has a mandate to achieve convergence with the IFRS issued by the IASB. The
HKFRSs and Interpretations of HKFRSs are developed through a due process that ensures the
accounting standards are of high quality and are introduced only after giving the stakeholders
opportunities to make their views known during the standard-setting process.
1.2.4.1 Roles of the Council of the HKICPA, Financial Reporting Standards Committee
(FRSC) and Regulatory Oversight Board (ROB)
Pursuant to section 18A of the Professional Accountants Ordinance, the HKICPA is the sole
financial reporting standard-setter in Hong Kong. Through its Council, FRSC and ROB, the
HKICPA developed and issued accounting standards in the public interest and bring about
convergence of accounting standards with the IFRS. The relationship among the parties
involved in the standard-setting process is illustrated in Exhibit 1.7.
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FINANCIAL REPORTING
HKICPA Council: Issue or specify any standards of accounting practices
Regulatory Oversight Board:
• Responsible for overseeing and advising HKICPA’s
overall strategy, policies and process for setting
financial reporting standards
Financial Reporting Standards Committee:
• Has mandate by Council to develop HKFRSs to achieve convergence
with IFRS
• Council permits FRSC to work in whatever way it considers most
effective and efficient
• Meeting every month
EXHIBIT 1.7 Roles of the Council, ROB and FRSC in the
context of standard-setting process
1.2.4.2 The Council
The Council of the HKICPA (the Council) serves as the governing body of the HKICPA, and
makes decisions on the overall strategy, policy and direction as well as matters stipulated in
the Professional Accountants Ordinance. It provides guidance on the HKICPA’s governance and
operations with the assistance of several monitoring and advisory committees.
1.2.4.3 The FRSC
The Council of the HKICPA has delegated the standard-setting function to the FRSC. In this
context, the FRSC may form advisory sub-committee or other forms of specialist advisory
groups to give advice in preparing new or revised HKFRSs. In addition, the FRSC is responsible
for providing guidance on a timely basis on financial reporting issues not specifically addressed
in the HKFRSs.
1.2.4.4 The ROB
The ROB is a monitoring committee of the Council to oversee the standard setting and the
regulatory functions of the HKICPA. An objective of the ROB is to advise the FRSC on priorities
and any major standard-setting projects and ensure the operations of the FRSC are aligned
with the strategies and policies set by the Council.
1.2.4.5 Standard-setting Structure and Process
Close co-ordination between the HKICPA’s and IASB’s due processes is an important factor in
the success of achieving convergence of the HKFRSs and the IFRS. The Council has, therefore,
aligned the HKICPA’s due process, including the timing of issuing Exposure Drafts, Standards,
and Interpretations, as closely as possible with the IASB’s due process as a result of its
convergence policy. The Preface to Hong Kong Financial Reporting Standards outlines the steps
taken by the Council in supporting the development of the IFRS and the implementation of the
HKFRSs in Hong Kong.
Under the HKICPA’s standard-setting due process, when the IASB starts a project, the
HKICPA adds it to its own project plans so it can participate in working towards an international
consensus.
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The process for setting standards is illustrated in Exhibit 1.8.
Hong Kong Standard-setting Process
International Standard- HKICPA Standard-Setting Hong Kong
Setting Boards Department Stakeholders
Discussion, information Discussion and information
sharing and contribution sharing
Identify issue Identify issue* Identify issue*
Stakeholder responses
Discussion, information
sharing and contribution
Add issue to agenda Add issue to agenda
HKICPA issues international
consultation papers
Research and Research and
Consultation Papers Discussion, information Consultation Papers
sharing and contribution
Discussion and information
Response to consultations sharing
Consider feedback and Comments from
Consider feedback
Discussion
develop own views Stakeholder responses stakeholders
HKICPA issues international Stakeholder education
Issue international standard standards Issue Hong Kong equivalent and outreach Implementation and
standard or other
or other pronouncement Education and discussion pronouncement compliance
HKICPA issues international Discussion and information
consultation papers sharing
Post- implementation Post- implementation Comments from
Review Review Stakeholder responses stakeholders
Response to consultations
and discussion
EXHIBIT 1.8 Hong Kong standard-setting process
As part of the due process, where the IASB has issued an exposure draft for comments,
the HKICPA will normally invite comments on the IASB’s exposure draft from its Hong Kong
constituents and other interested parties, which the HKICPA will then consider and may
include in its comments submitted to the IASB. Once the IASB has finished and issued a new
IFRS/Interpretation or revised IAS, the HKICPA will generally issue a new HKFRS/Interpretation
or revise the equivalent HKAS based on the IASB’s standard without exposing it for further
comment. In this way, the HKFRSs will be kept current on a timely basis as compared to the
IASB’s standards.
1.2.4.6 Relationship with the IFRS
Although the Council has a policy to achieve convergence of the HKFRSs with the IFRS, the
Council may consider it appropriate to include additional disclosure requirements in a HKFRS
or, in some exceptional cases, to deviate from an IFRS. Each HKFRS issued by the Council
contains information about the extent of compliance with the equivalent IFRS. Where the
requirements of a HKFRS and an IFRS differ, the HKFRS should be followed by entities reporting
within the area of application of the HKFRSs.
Key Learning Point
Although the HKICPA adopts the IFRS word for word as HKFRSs, the Council of the HKICPA
may impose requirements that deviate from an IFRS if appropriate.
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FINANCIAL REPORTING
1.2.4.7 Providing Interpretations or Rulings on Financial Reporting Issues
Because the full convergence of the HKFRSs with the IFRS in 2005, the Council of the HKICPA
has occasionally considered requests for interpretations and rulings received and determined
the relevant policy in 2007.
1.2.4.8 Interpretations
The FRSC will consider whether an issue warrants an interpretation by considering the tests for
development for an interpretation published by the IFRS IC, including whether:
• The issue is widespread and has practical relevance;
• The issue indicates that there are significant divergent interpretations (either emerging
or existing in practice);
• Financial reporting would be improved through the elimination of the diverse
reporting methods;
• The issue is a narrow implementation or application issue that can be resolved
efficiently within the confines of existing standards;
• The IFRS IC will probably be able to reach a consensus view on a timely basis; and
• The issue relates to a current or planned IASB project, and having a pressing need to
provide guidance sooner than would be expected from the IASB’s activities.
Where the FRSC determines that an issue meets the above criteria, the issue will be
forwarded to the IFRS IC for consideration. The results of the IFRS IC’s initial consideration will
be to take the issue on to its agenda or to explain why the IFRS IC should not address the issue.
When the IFRS IC declines to address the issue, the FRSC will determine the need for action.
Where the FRSC determines that an interpretation needs to be developed in Hong Kong,
the FRSC will develop a draft for public consultation. The FRSC will also seek comments from
the IFRS IC staff as to whether the proposal conflicts with the IFRS to minimise the possibility
that an interpretation developed in Hong Kong will damage the convergence of the HKFRSs
with the IFRS.
1.2.4.9 Rulings
Neither the Council nor staff of the HKICPA provides rulings on the appropriate treatments
under the HKFRSs in specific cases. The Council believes preparers of financial statements are
responsible for considering how to apply accounting principles.
1.2.4.10 Post-implementation Review of Financial Reporting Standards
Post-implementation Review (PIR) is a relatively new process to the IASB. The IASB carries
out a PIR of each new IFRS, generally after the standard has been implemented for two
years internationally. A PIR is an opportunity for the IASB to assess the effect of the new
requirements of an IFRS and of amendments on investors, preparers and auditors.
The objectives of a post-implementation review are:
• To review the important issues identified as contentious during the development of the
pronouncement; and
• To consider any unexpected costs or implementation problems.
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As of July 2022, the IASB carried out the PIR of the following standards:
• IFRS 8 Operating Segments (completed in 2013);
• IFRS 3 Business Combinations (completed in 2015);
• IFRS 13 Fair Value Measurements (completed in 2018);
• IFRS 10 Consolidated Financial Statements (completed in June 2022);
• IFRS 11 Joint Arrangements (completed in June 2022); and
• IFRS 12 Disclosure of Interests in Other Entities (completed in June 2022).
The first of a series of PIRs on IFRS 9 Financial Instruments – Classification and Measurement
is currently under way. The IASB is planning to undertake certain other PIRs (for example,
on IFRS 9’s impairment provisions and its hedging provisions).
Knowledge Check Question
Question 1
Referring to the Opening Case, identify which of the following pronouncements are
mandatory to Super Star when it prepares its HKFRSs financial statements for the financial
year ended 31 December 2018.
(I) Hong Kong Accounting Standards
(II) Hong Kong Interpretations
(III) Accounting Bulletins
(IV) Securities and Futures Ordinance
(V) Listing rules
(VI) Exposure Drafts on amendments to HKFRS 9 issued by HKICPA
A I, II, III
B I, II, VI
C I, II, IV
D I, III, IV
1 . 3 CONCEPTUAL FRAMEWORK FOR
FINANCIAL REPORTING
The HKICPA’s 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 should be communicated to the user. It is used to aid
the development of new accounting standards and the evaluation of those in existence, and
although theoretical in nature, a conceptual framework for financial reporting has highly
practical final aims.
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FINANCIAL REPORTING
Although the Conceptual Framework was not issued until October 2010, it was developed
from the previous Framework for the Preparation and Presentation of Financial Statements
(the Framework), which the HKICPA adopted in 1997.
Since 2005, the HKICPA has been revisiting the Framework with the objective of creating a
sound foundation for future accounting standards. In October 2010, the HKICPA issued a new
framework, Conceptual Framework for Financial Reporting 2010, containing two new chapters,
the Objectives and Qualitative Characteristics and the rest of the previous Framework that
was not adjusted. This long-running project was completed in 2018 by which HKICPA issued
a revised Conceptual Framework for Financial Reporting (2018) (Conceptual Framework). The
revised Conceptual Framework includes comprehensive changes to the previous Conceptual
Framework issued in 2010.
This section is based on the content of Conceptual Framework 2018 unless otherwise
specified.
1.3.1 Purpose, Status and Scope
Prior to the advent of Conceptual Framework, accounting standards were based on vague
principles and conventions, such as true and fair view, prudence and matching rather than on
a robust set of interrelated concepts reflecting underlying economic phenomena. Standard-
setters developed ‘rules’ that typically reflected emerging consensuses in practice. Decisions
made about standard development and application relied on an implicit personal conceptual
framework of the decision makers. As a result, decision tended to be ad hoc and inconsistent.
The Conceptual Framework was established with an aim to:
• Assist standard-setters in developing financial reporting standards based on explicit,
logical and consistent concepts;
• Assist preparers in developing accounting policies for transactions or events to which
no specific or similar standard applies or when a standard allows a choice of accounting
policy; and
• Assist all parties to understand and interpret the standards.
A conceptual framework improves the quality of financial reporting in the following aspects:
• Impose discipline on standard-setters to produce consistent decisions and become
accountable for their decisions;
• Provide a basis for the use of judgement in resolving accounting issues; and
• Provide the set of commonly understood concepts for effective engagement between
standard-setters and practitioners, which improves understanding of their respective
points of view.
However, the Conceptual Framework presents some limitations as well:
• Financial statements are drawn up to serve the interests of many user groups, and a
single conceptual framework may not satisfy the information needs of all users; and
• Although the Conceptual Framework provides the conceptually correct approach, in
practice, it is not always achieved at the standards level at any one time because of
pragmatic compromises.
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The Conceptual Framework is not a standard nor an AG: therefore, it does not override the
requirements in any standard. If a conflict or inconsistency occurs between the Conceptual
Framework and a standard, the requirements in the standard will take precedence. When
developing requirements for the HKFRSs, the HKICPA may sometimes specify requirements
that depart from aspects of the Conceptual Framework if doing so is needed to meet the
objective of financial reporting.
The Conceptual Framework contains the following key content elements:
• The objective of general purpose financial reporting;
• The qualitative characteristics of useful financial information;
• A description of the reporting entity and its boundary;
• Definitions of an asset, liability, equity, income and expenses and guidance supporting
these definitions;
• Criteria for including assets and liabilities in financial statements (recognition) and
guidance on when to remove them (derecognition);
• Measurement bases and guidance on when to use them;
• Concepts and guidance on presentation and disclosure; and
• Concepts of capital and capital maintenance.
Key Learning Point
The Conceptual Framework is not a HKFRS, and nothing in it overrides any specific HKFRS,
including a HKFRS that is in some respect in conflict with the Conceptual Framework.
1.3.2 The Objective of General Purpose Financial Reporting
The HKFRSs are designed to apply to the general purpose financial statements; therefore, the
concepts developed under the Conceptual Framework are based on the decision-making needs
of the users of the general purpose financial statements.
This section sets out the objective of general purpose financial reporting, the information
needed to achieve that objective and the primary users of financial reports.
1.3.2.1 Objectivity, Usefulness and Limitations of General Purpose Financial Reporting
The Conceptual Framework identifies existing and potential investors, lenders and other
creditors as the primary users of general purpose financial reporting. These users generally
cannot require entities to provide information directly to them, and therefore, they must
rely on financial reports for much of the financial information they need to make economic
decisions. General purpose financial reports are therefore focused on meeting the main needs
of such users.
Users of financial statements generally need information that enable them to assess:
• The prospects for future net cash inflows to an entity;
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• The resources of, and claims against, the entity; and
• Management’s stewardship of the entity’s economic resources.
The Conceptual Framework acknowledges that general purpose financial reports do not
and cannot provide all the information users may need to make economic decisions. They will
need to consider pertinent information from other sources, such as general economic and
political conditions and industry and company outlooks. Moreover, general purpose financial
reports are not designed to show the value of a reporting entity but to provide information to
allow users to estimate it for themselves.
The Conceptual Framework notes that other parties, including market regulators, may find
general purpose financial reports useful. However, these are not considered primary users and
general purpose financial reports are not primarily directed to regulators or other parties.
Specifying the objective of general purpose financial reporting is important because
standard-setters can have a clear objective in mind when developing accounting standards to
meet users’ information needs. Because that objective focuses on economic decision-making,
the concepts supporting that objective have been framed in a way that reflects the economic
substance of transactions and other events.
Key Learning Point
The objective of the general purpose financial reporting is to provide useful financial
information to existing and potential investors and creditors in making an economic
decision, which forms the foundation of the Conceptual Framework.
1.3.2.2 Economic Resources, Claims and Changes in Economic Resources and Claims
General purpose financial reports are intended to provide relevant decision-useful information
to primary users and other stakeholders about:
• The entity’s existing resources and claims against those resources (the financial position
of an entity); and
• The changes in economic resources and claims resulting from entity’s financial
performance and from other events.
Information about the nature and amounts of an entity’s economic resources and claims
assists users to assess that entity’s financial strengths and weaknesses, liquidity and solvency,
and its need and ability to obtain financing.
Changes in a reporting entity’s economic resources and claims can be resulting from that
entity’s performance and from other events or transactions, such as issuing debt or equity
instruments. Users need to be able to distinguish between both of these changes.
The Conceptual Framework puts an emphasis on accrual accounting to reflect the financial
performance of an entity. It means that the events should be reflected in the reports in the
periods when the effects of transactions occur even if the resulting cash receipts and payments
occur in a different period.
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Nevertheless, information about past cash flows (i.e. a reporting entity’s cash flows during
the reporting period) is important to users as it helps users to assess the entity’s ability to
generate future cash flows.
1.3.3 Qualitative Characteristics of Useful Financial Information
Qualitative characteristics are the attributes that make financial information useful to users.
The Conceptual Framework identifies ‘relevance’ and ‘faithful representation’ as fundamental
qualitative characteristics. These are supported by four enhancing qualitative characteristics of
comparability, verifiability, timeliness and understandability. However, these characteristics are
subject to cost constraints, and it is important to determine whether the benefits to users of
the information justify the cost incurred by the entity providing it.
1.3.3.1 Fundamental Qualitative Characteristics
If financial information is to be useful, it must both be relevant and provide a faithful
representation on what it purports to represent.
1.3.3.2 Relevance
Relevant financial information is capable of making a difference in the decisions made by users.
Information is relevant if it helps users of financial statements in predicting future trends of
the business (predictive value) or confirming or correcting any past predictions they have made
(confirmatory value). The same piece of information that assists users in confirming their past
predictions may also be helpful in forming future forecasts.
Materiality is related to relevance. Information is material if omitting, misstating or
obscuring it could reasonably be expected to influence decisions that the primary users of
general-purpose financial reports make on the basis of those reports, which provide financial
information about a specific reporting entity. Materiality is an entity-specific aspect of relevance
based upon the nature, magnitude or both of the items to which the information relates in
the context of an individual entity’s financial report. It is impossible to specify a quantitative
threshold for materiality or predetermine what could be material in a particular situation as it
depends upon the individual entity.
Illustrative Example 3
An entity discloses an increase in Earnings per Share (EPS) from HK$5 to HK$6 since the
last reporting period. The information is relevant to investors as it may assist them in
confirming their past predictions regarding the profitability of the company and will help
them in forecasting future trend in the earnings of the entity.
1.3.3.3 Faithful Representation
For information to represent an economic phenomenon faithfully, that information must reflect
the substance of the economic phenomenon and not merely its legal form. To be a perfectly
faithful representation, a depiction would have three characteristics: It would be complete,
neutral and free from error.
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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 no errors or omissions are 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.
The Conceptual Framework emphasises that neutrality should be supported by the exercise
of prudence, which is the exercise of caution when making judgements under conditions of
uncertainty. Because neutrality means depiction without bias, prudence is not biased towards
recognising fewer assets and more liabilities; therefore, assets and liabilities should be neither
overstated nor understated.
A faithful representation is also affected by a level of measurement uncertainty. When
a measure cannot be determined directly by observing prices in an active market and must
instead be estimated, measurement uncertainty will arise. A high level of measurement
uncertainty affects whether and how a faithful representation can be achieved.
1.3.3.4 Trade-off between Relevance and Faithful Representation
In some cases, a trade-off may need to be made between relevance and faithful representation,
specifically between relevance and measurement uncertainty. There may be cases where the
most relevant information about a phenomenon may be a highly uncertain estimate. In these
situations, when depending on facts and circumstances, the most useful information may
be that which is slightly less relevant but is subject to lower measurement uncertainty (as an
extreme example, measuring a complex financial instrument at cost instead of at a fair value
that is highly uncertain).
Apply and Analyse 1
Referring to the Opening Case, Super Star extended its business to property investment
and purchased a commercial building in Central (Building A) for leasing purposes in
October 2018. As allowed by accounting standard, Super Star can choose to measure
Building A at its historical cost or at fair value at the end of the reporting period. The fair
value of Building A can be reliably determinable through a valuation, which is based on
observable market information.
Which of the measurement methods provides more relevant and faithful
representation to users of the financial statements?
Analysis
Under historical cost accounting, Building A is valued at its original purchase value (less
depreciation), yet its net book value may differ significantly from its true worth to Super
Star. Therefore, users of the financial statements may underestimate the real worth
of business assets of Super Star. Moreover, historical cost does not provide timely
information about changes in value. Income and expenses reported on that basis may lack
predictive and confirmatory value by not faithfully depicting the full effect of Super Star’s
exposure to risk arising from holding the asset during the reporting period.
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Apply and Analyse 1 (continued)
Under fair value method, Building A is valued at the end of the reporting date to its
market value. This should result in more relevant information because users will be able to
better assess the value of potential benefits from the use or sale of Building A (predictive
value). Moreover, given that the measurement uncertainty is low (i.e. the fair value can be
reliably determined in this case), the fair value of Building A can be considered to provide
a faithful representation, together with sufficient disclosure of how the fair value has been
determined.
1.3.3.5 Enhancing Qualitative Characteristics
The usefulness of financial information is enhanced if it is comparable, verifiable, timely
and understandable. However, enhancing qualitative characteristics (either individually or
collectively) cannot make information useful if that information is irrelevant or not represented
faithfully.
1.3.3.6 Comparability
Information about a reporting entity is more useful if it can be compared with a similar
information about other entities and with similar information about the same entity for another
period or another date. Comparability enables users to identify and understand similarities in
and differences among items.
Consistency, though related to comparability, differs. Consistency refers to the use of the
same methods for the same items, from period to period within a reporting entity or within a
single period across entities. Comparability is the goal; consistency helps to achieve that goal.
1.3.3.7 Verifiability
Verifiability means that different knowledgeable and independent observers could reach
consensus, though not necessarily in 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.
In some cases, it is necessary to disclose forward-looking information in the financial
statements that is currently unverifiable but is of relevance to users. It is important in such
instances to disclose all necessary assumptions, methods and context relating to such
information to facilitate the users to assess whether the information is useful.
1.3.3.8 Timeliness
Timeliness means that information is 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,
for example, because some users may need to identify and assess trends.
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1.3.3.9 Understandability
Transactions and events must be accounted for and presented in the financial statements in a
manner that is easily understandable by a user who possesses a reasonable level of financial
knowledge and a willingness to study the information with reasonable diligence.
1.3.3.10 Application of the Qualitative Characteristics
The most efficient and effective process of applying the qualitative characteristics would usually
be as follows:
• Identify an economic phenomenon that has the potential to be useful to users of an
entity’s financial information;
• Identify the type of information regarding the phenomenon that would be most
relevant, if available and can be faithfully represented;
• Determine whether that information is available and can be faithfully represented; and
• Apply enhancing characteristics to confirm or enhance the quality of the information.
1.3.4 Going Concern Assumption
The Conceptual Framework identifies a going concern as an underlying assumption in
preparing financial statements.
Financial statements are normally prepared on the assumption that the reporting entity
is a going concern and will continue in operation for the foreseeable future. Hence, the entity
is assumed to have neither the intention nor the need to enter liquidation or to cease trading.
If such an intention or need exists, the financial statements may have to be prepared on a
different basis. If so, the basis used should be disclosed.
1.3.5 Reporting Entity
The Conceptual Framework states that the financial statements are prepared from the
perspective of the reporting entity as a whole and not from the perspective of any particular
group of investors, lenders, or other creditors.
The Conceptual Framework provides general guidance that a reporting entity is:
• An entity that chooses, or is required to, prepare financial statements;
• Not necessarily a legal entity in that the reporting entity can consist of only a portion
of a legal entity or can comprise two or more entities in which case combined financial
statements can be prepared where these entities do not have a parent-subsidiary
relationship with each other; and
• Defining the boundary of a reporting entity is difficult if it does not have typical
legal form. In this case, the Conceptual Framework recommends the boundary to
be determined by considering the users’ information needs of that entity, based
on the assumption that users need information that is relevant and faithfully
represented.
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1.3.6 Elements of Financial Statements
Financial statements provide information about the financial effects of transactions and other
events by grouping them into broad classes, that is, the elements of financial statements. This
section discusses the five elements of financial statements: assets, liabilities, equity, income
and expenses (Exhibit 1.9).
The elements of financial statements
Financial position Financial performance
• Assets • Income
• Liabilities • Expenses
• Equity
EXHIBIT 1.9 Information provided by
financial statements
1.3.6.1 Assets
An asset is defined as a present economic resource controlled by the entity as a result of past
events. An economic resource is a right that has the potential to produce economic benefits.
The definition of an asset focuses on the aspects outlined in Exhibit 1.10.
The definition emphasises that an asset is an economic
resource and that is not the ultimate in flow of economic
benefits that the economic resources may produce.
Economic resources
An economic resource can be an asset even if the probability
of its producing economic benefits is low (but if this is the case,
the recognition of the asset may be affected).
The definition clarifies that an economic resource should be
viewed as a set of rights (i.e. the right to use, sell or pledge
the object, as well as other undefined rights) over an object
rather than as a physical object as a whole.
Focus on rights In principle, each right could be a separate asset. However, to
present the underlying economics in the most concise and
understandable way, related rights will most commonly be
viewed collectively as a single asset (e.g. recognising a property
as a single asset instead of recognising the different rights
underlying the ownership of the property as different assets).
The concept of control is defined in the Conceptual Framework,
which encompasses both a power and a benefits element: an
entity must have the present ability to direct how a resource is
Control
used and be able to obtain the economic benefits from that
resource in order to control it. An economic resource can be
controlled by only one party.
EXHIBIT 1.10 Aspects of definition of asset
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1.3.6.2 Liabilities
A liability is defined as a present obligation of the entity to transfer an economic resource as
a result of past events. An obligation is a duty of responsibility that the entity has no practical
ability to avoid.
The definition of a liability focuses on the aspects outlined in Exhibit 1.11.
A present obligation exists as a result of past events only if the entity
has already obtained economic benefits or taken an action; and as a
consequence, the entity has the potential to transfer an economic
resource to another party (or parties). For that potential to exist, it
does not need to be certain, or even likely, that the entity will be
Present obligation as
required to transfer an economic resource.
a result of past events
The economic benefits obtained could include, for example, goods
or services. The action taken could include, for example, operating
a particular business or operating in a particular market. If economic
benefits are obtained, or an action is taken over time, the resulting
present obligation may accumulate over that time.
The focus is on whether the entity has the practical ability to avoid
a transfer of economic resources as opposed to whether it has a
theoretical right to avoid the transfer. If an entity has a theoretical
right to take action that would avoid an obligation, but has no
practical ability to exercise that right, that obligation binds the entity
No practical ability as effectively as if it did not have that theoretical right.
to avoid
The Conceptual Framework indicates that an entity may have no
practical ability to avoid a transfer it any action that it could take to
avoid the transfer would have economic consequences significantly
more adverse than the transfer itself. However, the practical ability
assessment will not be affected by management’s intention or the
likelihood of a transfer.
EXHIBIT 1.11 Aspects of definition of liabilities
Illustrative Example 4
A lessee enters into a non-cancellable two-year lease of an equipment with annual lease
payments of HK$40,000. According to HKFRS 16 Leases, the right to use the equipment
and the obligation to make lease payments are recognised as an asset and a liability at
the commencement date of the lease contract.
The lessee’s rights to use the equipment meets the definition of an asset because:
• The lessee’s right to use the equipment represents an economic resources that
has a potential to produce cash inflows by using the equipment to produce
goods for sale;
• The lessee has control over the right of use of the equipment, which can be
demonstrated by the ability of the lessee to determine how and for what purpose
the equipment is used throughout the lease period. Examples of decision-making
rights are deciding the type of output that is produced by the equipment and
deciding when the equipment will be used; and
• The lessee’s control of the right of use arises from past events, that is, the
equipment is being made available for use by the lessee for the duration of the
non-cancellable period of the lease.
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Illustrative Example 4 (continued)
The lessee’s obligation to pay lease payments meets the definition of a
liability because:
• The obligation arises from past events, that is, the lessee has a present obligation
to make lease payments once the underlying asset has been made to the lessee.
The lessee has no right to cancel the lease and avoid the contractual lease
payments; and
• The obligation results in a future outflow of economic benefits from the lessee,
that is, contractual cash payments.
1.3.6.3 Equity
An equity is defined as the residual interest in the assets of an entity after deducting all the
liabilities. It may be sub-classified in the statement of financial position in accordance with
legal, regulatory, or other requirements, for example, share capital or retained earnings.
Such classifications can be relevant to the decision-making needs of the users of financial
statements when they indicate legal or other restrictions on the ability of the entity to distribute
or otherwise apply its equity. For example, some requirements permit an entity to make
distributions to holders of equity only if the entity has sufficient reserves that the requirements
specify as being distributable.
1.3.6.4 Income and Expenses
Income is increases in assets, or decreases in liabilities, that result in increases in equity other
than those relating to contributions from holders of equity claims.
Expenses are decreases in assets, or increases in liabilities, that result in decreases in equity
other than those relating to distributions to holders of equity claims.
1.3.7 Recognition and Derecognition of the Elements of Financial
Statements
This section discusses the process and criteria for recognising assets and liabilities in financial
statements and provides guidance on when to remove or derecognise them.
1.3.7.1 Recognition Process
Recognition is ‘the process of capturing an asset or a liability for inclusion in the financial
statements’. Recognition links the elements to the statement of financial position and the
statement of financial performance as follows:
• In the opening and closing statements of financial position, total assets less total
liabilities equal total equity; and
• Recognised changes in equity during the period comprise:
°° income less expenses recognised in the statement(s) of financial performance; plus
°° contributions from holders of equity claims, less distributions to holders of
equity claims.
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This linkage is illustrated in Exhibit 1.12 (Conceptual Framework.5.4).
Opening statement of financial position
Assets less liabilities equal equity
Statement(s) of financial performance
Income less expenses
+ Changes
in equity
Contributions from holders of equity claims less
distributions to equity claims
Closing statement of financial position
Assets less liabilities equal equity
EXHIBIT 1.12 How recognition links the elements of
financial statement
The linkage between the statements arises because the recognition of one element
(or a change in one element) requires the recognition of an equal amount in one or more other
elements (or changes in one or more other elements). For example, income and expenses are
recognised in the statement(s) of financial performance only if an increase or decrease in the
carrying amount of an asset or a liability is also recognised.
1.3.7.2 Recognition Criteria
Failure to recognise items that meet the definition of an asset or a liability makes the statement
of financial position and the statement(s) of financial performance less complete and can
exclude useful information from financial statements. However, it does not mean all assets
and liabilities should be recognised. In some circumstances, the recognition of some items that
meet the definition of an asset or a liability can provide useless information.
The Conceptual Framework requires an entity to recognise an asset or a liability if such
recognition provides users of financial statements with:
• Relevant information about the asset or the liability and about any income, expenses or
changes in equity;
• Faithful representation of the asset or the liability and of any income, expenses or
changes in equity; and
• Information that results in benefits exceeding the cost of providing that information.
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The recognition of an asset of a liability may not produce relevant information in the
following cases:
• Whether an asset or a liability exists is uncertain;
• An asset or liability exists, but the probability of an inflow or outflow of economic
benefits is low.
Faithful representation may be affected by the level of measurement uncertainty. This may
be the case under highly uncertain circumstances where:
• The range of possible outcomes is wide and the probability of each outcome is difficult
to estimate;
• The measure is sensitive to small changes in estimates of the probability of different
outcomes; or
• The measure requires difficult or subjective allocations of cash flows difficult to
distinguish from other elements.
In limited circumstances, all relevant measures may be subject to high measurement
uncertainty, such that the asset should not be recognised. If an item meeting the definition of
an asset or a liability is not recognised, disclosures may be needed.
Illustrative Example 5
A lease conveys the lessee a right to control the use of an equipment for three years
at a fixed annual lease payment of $10,000. Such right and the related liability should
be recognised on the statement of financial position because they provide useful
information to investors by:
• Providing relevant information about the asset and the liability of the lessee.
The existence of the right to use of an asset and the obligation to pay the lease
payments are certain as they are arising from a lease contract entered into
between the lessee and the lessor. The recognition of such an asset and a liability
can provide investors with an accurate picture of a company’s assets and financial
leverage; and
• Providing a faithful representation of the asset and the liability of the lessee.
The substance of leasing transaction is similar to borrowing a fund from lessor
to purchase an asset. The recognition of a right of use asset and a lease liability
improves comparability between companies that lease assets and companies that
borrow to buy assets. Because the lease term and the annual lease payments are
fixed by the contract, the level of uncertainty involved in estimating a measure of
an asset or liability is likely to be low.
1.3.7.3 Derecognition
Derecognition is the removal of all or part of a previously recognised asset or liability from an
entity’s statement of financial position. For an asset, this normally occurs when the entity loses
control of all or part of the previously recognised asset; for a liability, this normally occurs when
the entity no longer has a present obligation for all or part of the previously recognised liability.
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The Conceptual Framework states that derecognition should aim to represent faithfully:
• The resources and obligations remaining after the transaction; and
• The changes in the resources and obligations because of a transaction.
Normally, a faithful representation of a transfer of an asset or liability is achieved by:
• Derecognising any assets or liabilities transferred, consumed, collected or fulfilled, or
have expired and recognising any resulting income or expense; and
• Continuing to recognise the assets or liabilities retained, if any (the retained
component). Accordingly, no income or expenses are recognised on the retained
component as a result of the derecognition of the transferred component.
However, in some cases, it may be necessary to continue to recognise a transferred
component of an asset or liability together with a liability or asset for the proceeds received or
paid if derecognition would not faithfully represent the transferor’s assets, liabilities, income
and expenses. This may be the case when an entity disposes of only part of an asset or a
liability while retaining exposure to significant positive or negative variations in the amount of
economic benefits that may be produced by the asset or the liability.
1.3.8 Measurement of the Elements of Financial Statements
Measurement means ‘in what amount’ to recognise an asset, liability, equity, income or
expense in financial statements. This section discusses the measurement bases identified in
the Conceptual Framework and factors to consider when selecting a measurement basis.
Two categories of measurement basis were identified in the Conceptual Framework:
1. Historical cost measurement basis, and
2. Current value measurement basis.
The Conceptual Framework asserts that both bases can provide predictive and
confirmatory value to users, but one basis might provide more useful information than the
other under different circumstances. As such, the Conceptual Framework does not favour one
measurement basis over the other.
1.3.8.1 Historical Cost
Historical cost reflects the price of the transaction or other event that gave rise to the related
asset, liability, income or expense. For an asset, this would be the cost incurred in acquiring
and creating the asset and in comprising the consideration paid plus transaction costs. For a
liability, this would be the value of the consideration received to incur and take on the liability
minus transaction costs.
This historical cost will be updated over time to depict, where applicable:
• For an asset, the consumption of the asset (depreciation or amortisation); payments
received that extinguish the asset; the effect of events that cause part or all of the
historical cost of the asset to be no longer recoverable (impairment); and the accrual of
interest to reflect any financing component of the asset.
• For a liability, the fulfilment of the liability (e.g. by making payments or by delivering
goods); the effect of events that increase the value of the obligation to such an extent
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that the liability becomes onerous; and the accrual of interest to reflect any financing
component of the liability.
One way to apply a historical cost measurement basis to financial assets and financial
liabilities is to measure them at amortised cost. More details are covered in Chapter 12.
1.3.8.2 Current Value
Current value provides monetary information about assets, liabilities and related income and
expenses using information updated to reflect conditions at the measurement date.
Current value measurement bases include fair value, value in use or fulfillment value and
current cost (Exhibit 1.13).
• 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
• Reflects market participants’ current expectations about the amount,
Fair value timing and uncertainty of future cash flows
• Exit value (more details are covered in Chapter 4)
• Present value of future cash flows from the continuing use of the asset
and from its disposal (or fulfilling the liability)
• Reflects entity-specific current expectations about the amount, timing and
Value in use (for
uncertainty of future cash flows.
asset) or fulfilment
• Exit value
value (for liability)
• Reflects the current amount that would be:
- Paid to acquire an equivalent asset
- Received to take on an equivalent liability
Current cost • Entry value (more details are covered in Chapter 4)
EXHIBIT 1.13 Current value measurement bases
1.3.8.3 Factors to Consider in Selecting a Measurement Basis
The objective in selecting a measurement basis is consistent with that of financial statements,
that is, to provide relevant information that faithfully represents the underlying substance of a
transaction. Cost will also constrain the selection of a measurement basis.
No single factor determines when selecting an appropriate measurement basis. The relative
importance of each factor will depend on facts and circumstances.
1.3.8.4 Relevance
Relevance of information provided by a measurement basis is affected by the characteristics
of the asset or liability and by contribution to future cash flows. For example, if an asset is
sensitive to market factors, fair value might provide more relevant information than historical
cost. However, depending on the nature of entity’s business model and how the asset is
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expected to contribute to future cash flows, fair value might not provide relevant information.
This could be the case if the entity holds the asset solely for use or to collect contractual cash
flows rather than for sale.
1.3.8.5 Faithful Representation
Faithful representation of information provided by a measurement basis is affected by
measurement inconsistency and measurement uncertainty.
When assets and liabilities are related in some way, using different measurement bases for
those assets and liabilities can create a measurement inconsistency. Under this circumstance,
financial statements may not faithfully represent some aspects of the entity’s financial
position and financial performance. Consequently, in some circumstances, using the same
measurement basis for related assets and liabilities may provide more useful information.
Measurement uncertainty does not necessarily prevent the use of a measurement basis
that provides relevant information. However, if the measurement uncertainty is too high, which
might make it necessary to consider selecting a different measurement basis.
Consideration of all these factors is likely to result in the selection of different measurement
bases for different assets, liabilities, income and expenses.
1.3.9 Concepts of Capital and Capital Maintenance
Concepts of capital maintenance are important only as income earned in excess of amounts
needed to maintain capital may be regarded as profit.
The Conceptual Framework identifies two broad concepts of capital maintenance:
1. Financial capital maintenance: Under this model, capital is defined in terms of net
assets or equity of the entity. A profit is earned only if the financial (or money) amount
of the net assets at the end of the period exceeds the financial (or money) amount of
the net assets at the beginning of the period after excluding any distributions to and
contribution from owners during the period. Such concept can be measured in nominal
monetary units or in units of constant purchasing power.
2. Physical capital maintenance: Under this model, capital is defined in terms of the
physical productive capacity. A profit is earned only if the physical productive capacity
of the entity at the end of the period exceeds the physical productive capacity at the
beginning of the period after excluding any distributions to and contributions from
owners during the period.
The principal difference between the two concepts is the treatment of the effects of the
changes in the prices of assets and liabilities of the entity. Under the financial concept, the
increases in the price of assets is regarded as profits; in physical maintenance concept, the
changes in price of the assets of the entity are regarded as changes in the physical productive
capacity of the entity, which are, therefore, treated as capital maintenance adjustments within
equity and not as profit.
The concept of capital maintenance chosen by an entity will determine the accounting
model used in the preparation of its financial statements. Most entities adopt a financial
concept of capital. The selection of the appropriate concept of capital maintenance depends
on the needs of users. The Conceptual Framework does not indicate a preference for either of
these concepts of capital maintenance.
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1.3.10 Conceptual Framework and HKAS 1 (Revised) Presentation of
Financial Statements
A reporting entity communicates information about its assets, liabilities, equity, income
and expenses by presenting and disclosing information in its financial statements. Effective
communication of information in financial statements makes that information more relevant
and contributes to a faithful representation of an entity’s assets, liabilities, equity, income and
expenses. The Conceptual Framework states that effective communication of information could
be achieved by:
• Focusing on presentation and disclosure objectives and principles rather than on rules;
• Classifying information in a manner that groups similar items and separates dissimilar
items; and
• Aggregating information in such a way that is not obscured by unnecessary detail or
excessive aggregation.
Effective communication in financial statements is also supported by considering the
following principles:
• Entity-specific information is more useful than standardised descriptions, sometimes
referred to as ‘boilerplate’; and
• Duplication of information in different parts of the financial statements is usually
unnecessary and can make financial statements less understandable.
1.3.10.1 Financial Statements
The Conceptual Framework provides a high-level principle that the financial statements include
the following elements:
• The statement of financial position, which records assets, liabilities and equity;
• The statement(s) of financial performance, recognising income and expenses; and
• Other statements and notes, with the latter explaining the elements recognised in the
statements, the elements that have not been recognised, cash flows, contributions from
holders of equity claims and distributions to them, and the methods, assumptions and
judgements used in preparing the financial statements.
Apart from specifying the elements of financial statements, HKAS 1 (Revised) Presentation of
Financial Statements contains a list of specific items required to be disclosed on the face of the
statement of financial position, statement of profit or loss and other comprehensive income,
and statement of changes in equity.
1.3.10.2 Profit or Loss and Other Comprehensive Income
The Conceptual Framework uses the term statement(s) of financial performance to refer to
the statement of profit or loss together with the statement presenting other comprehensive
income (OCI).
The Conceptual Framework does not make a conceptual distinction between profit or loss
and OCI. It does not specify when including items in OCI may be appropriate, nor does it specify
when subsequent reclassification may be appropriate. All these decisions will be made when
developing individual standards.
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The Conceptual Framework provides a general principle that the statement of profit or
loss is the primary source of information about an entity’s financial performance for the
reporting period. It presumes that all income and expenses are presented in profit or loss.
Only in exceptional circumstances would standard-setter make a decision to include income or
expenses in OCI. It further explains that those exceptional circumstances would be when the
relevance or faithful representation of the information provided in the statement of profit or
loss could be enhanced by excluding particular income and expenses from that statement and
including those items in OCI.
The Conceptual Framework also presumes that items presented in OCI will be reclassified
from OCI to profit or loss, but reclassification must provide more relevant information than
not reclassifying the amounts. If there is no clear basis that this will result in more useful
information about an entity’s profit or loss in a future period, the standard-setter may decide
reclassification should not take place.
HKAS 1 (Revised) provides detailed requirements that all items of income and expense shall
be presented either:
• In a single statement of profit or loss and other comprehensive income; or
• In two separate statements, one being a statement of profit or loss and the other being
a statement of other comprehensive income.
The terms profit or loss and other comprehensive income are defined in HKAS 1 (Revised)
Presentation of Financial Statements, which further sets out the specific items that should be
included in OCI and whether and when amounts previously recognised in OCI are reclassified
to profit or loss.
Knowledge Check Questions
Question 2
When developing requirements for the HKFRS Standards, explain whether the HKICPA can
depart from the Conceptual Framework.
A The HKICPA cannot depart from the Conceptual Framework due to the convergence
policy with the IFRS.
B The HKICPA cannot depart from the Conceptual Framework as all HKFRSs standards can
only be developed based on the Conceptual Framework.
C The HKICPA can depart from the Conceptual Framework when doing so could save more
costs for preparers.
D The HKICPA can depart from the Conceptual Framework when doing so is needed to
meet the objective of financial reporting.
Question 3
Identify which of the following describes prudence as in the Conceptual Framework.
A A bias towards understating assets or income and towards overstating liabilities
or expenses.
B A preference towards the earlier recognition of expenses and liabilities than of income
and assets.
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Knowledge Check Questions (continued)
C The exercise of caution when making judgements under conditions of uncertainty.
D A mechanism for smoothing profits over time.
Question 4
Identify which of the following situations does not meet the definition of a liability.
A Management does not have an intention to repay the bank loan.
B A retail store has a generally known policy of refunding purchases by dissatisfied
customers.
C An entity was charged with late filing penalties by the Inland Revenue Department due to
late tax filing. The amount of penalty is not known by the end of the reporting period.
D An entity has entered into a contract to pay an employee a salary in exchange for
receiving the employee’s services.
1 . 4 FIRST-TIME ADOPTION OF HKFRS
The purpose of HKFRS 1 (Revised) First-time Adoption of Hong Kong Financial Reporting Standards
is to establish the rules for entities preparing their financial statements in accordance with the
HKFRSs for the first time, particularly regarding the transition from the accounting principles
previously applied by the entity (previous GAAP).
As HKFRS 1 (Revised) only applies to entities adopting HKFRSs for the first time, its
application in practice is expected to be limited.
1.4.1 Overview
HKFRS 1 (Revised) specifies the requirements that an entity must follow when it first adopts the
HKFRS as the basis for preparing its general purpose financial statements. HKFRS 1 (Revised)
refers to these entities as first-time adopters.
The objective of HKFRS 1 (Revised) is to ensure that an entity’s first HKFRS financial
statements, including interim financial reports, present high-quality information that
(HKFRS 1.1):
• Is transparent and comparable over all periods presented;
• Provides a suitable starting point for accounting under HKFRSs; and
• Can be prepared at a cost that does not exceed the benefits.
This section provides high-level summaries for the standard, specifically in areas relating to
scope of application, recognition, measurement as well as presentation and disclosures.
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FINANCIAL REPORTING
1.4.1.1 Terminology
Appendix A to HKFRS 1 (Revised), which is an integral part of the HKFRS, contains defined
terms that are used in the standard. The following sets out some of those definitions and
explanations that are frequently used throughout this section (Exhibit 1.14).
Terms Definitions
Date of transition to a HKFRSs The beginning of the earliest period for which an entity presents
full comparative information under the HKFRSs in its ‘first HKFRS
financial statements’ (defined below).
First HKFRS financial statements The first annual financial statements in which an entity adopts
HKFRS by making an explicit and unserved statement of
compliance with HKFRS.
First HKFRS reporting period The reporting period ending on the reporting date of an entity’s
first HKFRS financial statements.
First-time adopter An entity that presents its first HKFRS financial statements.
Opening HKFRS statement of An entity’s statement of financial position at the date of
financial position transition to HKFRSs.
Previous GAAP The basis of accounting that a first-time adopter used
immediately before adopting HKFRSs.
EXHIBIT 1.14 Terms defined in Appendix A of HKFRS 1 (Revised)
1.4.1.2 Scope of HKFRS 1 (Revised)
An entity should apply HKFRS 1 (Revised) in:
• Its first HKFRS financial statements; and
• Each interim financial report, if any, prepared in accordance with HKAS 34 Interim
Financial Reporting for part of the period covered by its first HKFRS financial statements.
A careful assessment of the specific facts and circumstances is required to determine
whether financial statements fall within the scope of HKFRS 1 (Revised). The standard provides
specific examples of what might or might not qualify as an entity’s first HKFRS financial
statements.
HKFRS 1 (Revised) indicates that financial statements under the HKFRSs are an entity’s first
HKFRS financial statements if, for example, the entity presented its most recent previous
HKFRS 1.3 financial statements:
• Are under other accounting requirements inconsistent with the HKFRSs in all respects;
• Conform with HKFRSs in all respects except that the financial statements did not
contain an explicit and unreserved statement that they complied with the HKFRSs;
• Contain an explicit statement of compliance with some HKFRSs.
An entity whose most recent previous financial statements contained an explicit and
unserved statement of compliance with the HKFRSs can never be considered a first-time
HKFRS 1.4 adopter. This is the case even in the following circumstances:
• The entity issued financial statements containing an explicit and unserved statement of
compliance with the HKFRSs even though the auditors issued a qualified audit report on
those HKFRS financial statements;
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• The entity issued financial statements claiming to comply with other accounting
requirements and with the HKFRSs; or
• The entity stops presenting a separate set of financial statements under other
accounting requirements, which was presented in addition to its HKFRS financial
statements.
Key Learning Point
An entity’s first HKFRS financial statements will be subject to HKFRS 1 when the entity
adopts the HKFRSs by making in those financial statements an explicit and unreserved
statement of compliance with the HKFRSs.
Illustrative Example 6
Entity A applied the HKFRSs in its previous financial statements but stated that it ‘applied
HKFRS except for HKFRS 2 Share-based Payment’.
Entity A is a first-time adopter because its financial statements did not contain an
unreserved statement of compliance with HKFRS. Whether the auditors’ report was
qualified or not is irrelevant.
Entity B applied the HKFRS in its 20X7 financial statements and stated the ‘financial
statements were prepared in conformity with the HKFRS’. Despite that statement, Entity B
had not applied HKFRS 2, and with a qualified audit opinion.
Entity B is not within the scope of HKFRS 1 (Revised) for its 20X8 financial statements.
Though Entity B should not have claimed unreserved compliance with the HKFRSs for its
20X7 financial statements, those financial statements have been considered the HKFRS
compliant and relied upon as such.
1.4.1.3 First-time Adoption Timeline
An entity’s first financial statements should include at least three statements of financial
position (including one at the date of transition, that is, at the beginning of the comparative
period), two statements of profit or loss and other comprehensive income, two statements of
cash flows and two statements of changes in equity and related notes, including comparative
HKFRS 1.21 information for all statements presented.
The beginning of the earliest comparative period for which the entity presents full
comparative information under the HKFRSs will be treated as its date of transition to
the HKFRSs.
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Illustrative Example 7
Referring to the Opening Case, Super Star’s year-end is 31 December and is required to
produce HKFRS financial statements for the first accounting period starting on or after
1 January 2018.
Super Star is within the scope of HKFRS 1 (Revised) as its most recent financial
statements were prepared under Japanese GAAP and did not contain an unreserved
statement of compliance with the HKFRS. Super Star’s first HKFRS financial statements
are for the period ending on 31 December 2018. Its date of transition to the HKFRSs is
1 January 2017, which is the beginning of the single comparative period included in its first
HKFRS financial statements.
Exhibit 1.15 illustrates how Super Star determines its date of transition to the HKFRSs
and its first HKFRS reporting date as defined in HKFRS 1 (Revised).
Last financial statements under previous GAAP
First HKFRS
Comparative period
reporting period
First HKFRS financial statements
31/12/2015 1/1/2017 1/1/2018 31/12/2018
Begining of the first
Date of transition to First HKFRS
HKFRS reporting
HKFRSs reporting date
period
EXHIBIT 1.15 Date of transition and first reporting date as defined in HKFRS
1.4.2 Recognition and Measurement
In principle, HKFRS 1 (Revised) requires entities to apply retrospectively all HKFRS effective at
the end of the entity’s first HKFRS reporting period to all comparative periods presented as if
they had always been applied.
Illustrative Example 8
Referring to the Opening Case, Super Star adopted the HKFRSs for the year ended
31 December 2018, so it must apply all HKFRSs effective at that date retrospectively to
the 2018 and 2017 reporting periods and to the opening statement of financial position
on 1 January 2017 (assuming only one year of comparative information is provided).
Exhibit 1.16 illustrates how Super Star determines the accounting policies for the first
HKFRS reporting period.
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Illustrative Example 8 (continued)
Apply the same accounting policies for all periods
1/1/2017 31/12/2017 31/12/2018
Date of transition to HKFRS First HKFRS reporting date
HKFRSs effective at this
date applied
retrospectively (subject
to exceptions and
exemptions)
EXHIBIT 1.16 Accounting policies for the first HKFRS reporting period
However, HKFRS 1 (Revised) adapts the general principle of retrospective application by
adding a number of ‘mandatory exceptions’ and ‘optional exemptions’.
1.4.2.1 Mandatory Exceptions
HKFRS 1 (Revised) prohibits retrospective application of the HKFRSs in some areas, particularly
where this would require judgements by management about past conditions after the outcome
of a particular situation is known. The reasoning behind most of such exceptions is that
retrospective application of the HKFRSs in these situations could easily result in an
HKFRS unacceptable use of hindsight and lead to arbitrary or biased restatements, which would be
1.13–1.17 neither relevant nor reliable.
1.4.2.2 Optional Exemptions
Optional exemptions from the retrospective application of the HKFRS are granted on first-time
adoption in specific areas where the cost of complying with the general requirements of HKFRS 1
(Revised) would be likely to exceed the benefits to users of financial statements or where the
HKFRS 1.18 retrospective application is impractical. Application of these exemptions is entirely optional.
1.4.2.3 Steps in Transition to HKFRS
Transitions to HKFRS involves the following steps:
• Prepares an opening HKFRS statement of financial position at the date of transition.
This is the starting point for an entity’s accounting in accordance with HKFRSs;
• Applies the HKFRSs that are effective at the end of its first HKFRS reporting period in the
first HKFRS financial statements;
• Recognises all assets and liabilities in accordance with the requirements of the HKFRSs
and derecognises assets and liabilities that do not qualify for recognition under the
HKFRSs;
• Reclassifies items in accordance with the HKFRSs;
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FINANCIAL REPORTING
• Measures all recognised assets and liabilities according to principles under the HKFRSs;
• With limited exceptions, estimates in accordance with the HKFRSs at the date
of transition must be consistent with estimates made for the same date under
previous GAAP;
• Determines the impact of applying the exceptions and the exemptions at the date of
transition; and
• Complies with all the presentation and disclosure requirements of HKFRS 1 (Revised).
1.4.3 Presentation and Disclosure
An entity’s first financial statements are required to comply with the presentation and
disclosure requirements of HKAS 1 (Revised) and the other standards and interpretations under
the HKFRSs. HKFRS 1 (Revised) does not provide any relief from the presentation and disclosure
requirements of the individual Standards. Additional requirements of HKFRS 1 (Revised) are
outlined below.
1.4.3.1 Explanation of Transition to HKFRSs
First-time adopters are required to explain how the transition from previous GAAP to the
HKFRSs affected their previously reported financial position, financial performance and
cash flows. To comply with this requirement, HKFRS 1 (Revised) requires the presentation of
reconciliation in an entity’s first HKFRS financial statements.
1.4.3.2 Interim Reporting
If a first-time adopter presents an interim financial report under HKAS 34 Interim Financial
Reporting for part of the period covered by its first HKFRS financial statements, HKFRS 1
(Revised) will require additional disclosures in that interim report, including reconciliation
between previous GAAP and the HKFRSs. Comparative information is required to be restated in
accordance with HKAS 34 Interim Financial Reporting.
1.4.3.3 Other Disclosure Requirements
Specific disclosures are required if a first-time adopter elects to apply certain exemption
options as permitted under HKFRS 1 (Revised).
1.4.3.4 Non-IFRS Comparative Information and Historical Summaries
Entities are permitted to present historical summaries data for periods before the date of
transition, which do not comply with the HKFRSs, as long as the information is prominently
labelled as not being prepared in accordance with the HKFRSs.
1 . 5 CURRENT DEVELOPMENTS
To increase the communication effectiveness of financial statements, the IASB decided that
‘Better Communication’ will be a central theme of its work in the coming years. The IASB will
take a fresh look at how financial information is presented, how it is grouped together and in
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what form it is made available. The main projects that will contribute to this mission are the
project on primary financial statements and the Disclosure Initiative.
1.5.1 Primary Financial Statements Project
This project is intended to help users better understand and compare information published in
companies’ general-purpose financial statements.
The IASB issued an Exposure Draft ED/2019/7 General Presentation and Disclosures in
December 2019, which proposes improvements to the statements of financial performance
and of cash flows. The changes will include improved classification with more subtotals, more
consistent reporting of subtotals and better disaggregation. The IASB expects these changes
to improve the usefulness of information by improving users’ ability to evaluate companies
over time and to compare companies. The IASB is currently considering the comments on the
Exposure Draft.
1.5.2 Disclosure Initiative
The IASB launched its Disclosure Initiative in 2013 to respond to feedback that improving the
effectiveness of disclosures in financial statements is unnecessary. The Disclosure Initiative
is referred to a package of projects that included targeted actions to improve the disclosures
in IFRS Standards and to help entities apply better judgement when preparing financial
statements.
The IASB decided to focus on the following areas:
• Accounting policy disclosures: To develop guidance and examples to help entities apply
materiality judgements to accounting policy disclosure; and
• Targeted standards-level review of disclosures: To develop guidance designed to
improve the way the IASB develops disclosure objectives and requirements and test
that guidance by applying it to the IFRS.
The IASB has completed its work on accounting policies and materiality and is currently
exposing proposals in response to its targeted standards-level review of disclosures.
1.5.3 Management Commentary
The IASB is currently reviewing Practice Statement 1. It is too early to judge how that review
might impact the guidance in Accounting Bulletin 5 on the preparation and presentation of the
business review required by the Companies Ordinance.
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FINANCIAL REPORTING
SUMMARY
• The IFRS is widely accepted as a set of high-quality and transparent global standards that are
intended to achieve consistency and comparability and global convergence.
• With effect from 1 January 2005, the HKFRSs were fully converged with the IFRS issued by the
IASB. From that onward, the HKICPA adopts the IFRS word for word as the HKFRSs.
• Although the Council of HKICPA has a policy to achieve convergence of HKFRSs with the IFRS,
the Council may consider it appropriate to include additional disclosure requirements in a
HKFRS or, in some exceptional cases, to deviate from the individual IFRS.
• The term HKFRS includes all HKFRSs, HKASs, and Interpretations issued by the HKICPA.
• HKFRSs apply to all general-purpose financial statements, which have an objective to provide
information about the financial position, performance and cash flows of an entity useful to
those users in making economic decisions.
• The Conceptual Framework is the cornerstone of high-quality financial reporting, which
facilitate the consistent and logical formulation of financial reporting standards and provides a
basis for the use of judgement in resolving accounting issues.
• The objective of HKFRS 1 (Revised) is to ensure that an entity’s first HKFRS financial
statements, including interim financial reports, present high-quality information that:
°° Is transparent and comparable over all periods presented;
°° Provides a suitable starting point for accounting under HKFRSs; and
°° Can be prepared at a cost that does not exceed the benefits.
• An entity should apply HKFRS 1 (Revised) in its first HKFRS financial statements and each
interim financial report, if any, prepared in accordance with HKAS 34 Interim Financial
Reporting for part of the period covered by its first HKFRS financial statements.
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MIND MAP
REGULATED BODIES FINANCIAL REPORTING REQUIREMENTS
HKICPA Mandatory
FRC • HKFRSs
• HKASs
HKEx
HONG KONG • Interpretations
SFC FINANCIAL Advisory
HKIA REPORTING • Accounting Guidelines
HKMA FRAMEWORK • Accounting Bulletins
• Conceptual Framework
FIRST-TIME ADOPTION
STANDARD-SETTING PROCESS
Scope
Recognition and Measurement Identify issue
• Mandatory exceptions Add issue to agenda
• Optional exemptions Consultation (e.g. exposure draft)
Presentation and Disclosure Consider feedback
Issue final standard or other pronouncement
Post-implementation Review
OBJECTIVE OF GENERAL PURPOSE REPORT PRESENTATION
Primary users Elements of financial statements
• Investors • Financial position
• Lenders • Financial performance
• Other creditors • Other statements and notes
Useful information for decision making Specific requirements in HKAS 1
• Prospect of future net cash inflows
• Resources and claims QUALITATIVE CHARACTERISTICS OF USEFUL
• Management’s stewardship FINANCIAL INFORMATION
Fundamental
UNDERLYING ASSUMPTIONS
• Relevance
Going concern • Faithful representation
CAPITAL MAINTENANCE Enhancing
• Comparability
Financial concept • Verifiability
Physical maintenance concept • Timeliness
• Understandability
ELEMENTS OF FINANCIAL STATEMENTS CONCEPTUAL
MEASUREMENTS
Assets FRAMEWORK
Historical cost
Liabilities
Current value
Equity
• Fair value
Income and expenses • Value in use (for assets)/fulfillment value
RECOGNITION CRITERIA (for liabilities)
• Current cost
Relevance
REPORTING ENTITY
Faithful representation
Cost constraint Not necessarily a legal entity
Focus on information needs of users
DERECOGNITION
Asset–lose control of all or part of it
Liability–no longer has a present obligation
for all or part of it
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FINANCIAL REPORTING
Answers to Knowledge Check Questions
Question 1
Answers A, B and D are incorrect.
Answer C is correct: I, II, IV.
(I) The term HKFRS includes Hong Kong Accounting Standards (HKAS), issued by HKICPA;
therefore, Super Star must apply them.
(II) The term HKFRS includes all Interpretation issued by the HKICPA, including Hong Kong
Interpretations; therefore, Super Star must apply them.
(III) Accounting Bulletins are informative publication issued by HKICPA. They are not part of the
HKFRS; therefore, Super Star need not apply them.
(IV) Super Star is subjected to the reporting requirements under Securities and Futures
Ordinance as it is a corporation granted with a license by SFC.
(V) Super Star is not a listed company; therefore, listing rules are not applicable.
(VI) Exposure Drafts represent proposed standards and interpretation. The proposals in an
exposure draft will become effective only after going through the standard-setting due
processes; therefore, Super Star need not apply them.
Question 2
Answer A is incorrect. The ability to depart from the Conceptual Framework is also
included in the IFRS. Consequently, no violation of convergence policy exists.
Answer B is incorrect. The Conceptual Framework contains no requirement that all HKFRSs
can only be developed based on the Conceptual Framework.
Answer C is incorrect. The HKICPA cannot depart from the Conceptual Framework for
reasons other than meeting the objective of financial reporting.
Answer D is correct. Conceptual Framework states the HKICPA may sometimes specify
requirements that depart from aspects of the Conceptual Framework to meet the objective
of general-purpose financial reporting (Conceptual Framework SP1.3).
Question 3
Answers A and B are incorrect. The Conceptual Framework clearly state that assets and
liabilities should be neither overstated nor understated in exercise of prudence.
Answer C is correct. Conceptual Framework states that prudence is the exercise of caution
when making judgements under conditions of uncertainty (Conceptual Framework 2.16).
Answer D is incorrect. Smoothing of profits will result in understatement of profits in good
years and the overstatement of profits in bad years, which are disallowed in the exercise
of prudence.
Question 4
Answer A is incorrect. It meets the definition of liability because the bank loan is a present
obligation. Management’s intention to settle or not is irrelevant.
Answer B is incorrect. It meets the definition of liability because the entity does not have
a practical ability to avoid a transfer of resources because the customer knows the refund
policy. The economic consequences (e.g. damage of reputation) of avoiding refund is
considered more adverse than the refund.
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Answer C is incorrect. It meets the definition of liability as the act of late filing is a present
obligation. The uncertainty of the amount of late filing penalty only affect the recognition
and measurement of liability but not the existence of liability.
Answer D is correct. An entity does not have a present obligation to pay the salary until it
has received the employee’s services. The contract is an executory contract at the time of
signing the contract.
EXAM PRACTICE
QUESTION 1
‘To present fairly the financial position of an entity, all the items that meet the definition of
an asset should be recognised on the statement of financial position’.
Required:
(a) Explain why the above statement is incorrect.
(b) Outline the advantages of the Conceptual Framework.
QUESTION 2
‘Income and expenses included in other comprehensive income must subsequently be
reclassified to profit or loss’
Required:
Explain why the above statement is incorrect based on the guidance in the Conceptual
Framework.
QUESTION 3
Entity Y is considering two possible agreements to sell its trade receivables to a bank to
improve its liquidity. The two agreements are described as below:
1. Entity Y could sell HK$10 million of the receivables to a bank by receiving 80% of the
funds in full and final settlement. The factoring is non-recourse, and Entity Y has no
obligation to refund the bank of irrecoverable trade receivables.
2. Alternatively, the bank would initially pay Entity Y with 30% of the HK$10 million
receivables sold. Further amounts will become payable to Entity Y if the bank receives
cash from customers in settling the trade receivables. The bank has full recourse to
Entity Y, which means Entity Y has an obligation to buy back any uncollected receivables
from the bank.
Required:
Explain how the principles in the Conceptual Framework could help Entity Y determine the
accounting treatment for its trade receivables under the two agreements.
QUESTION 4
(Adapted from Final Exam December 2016 Paper 1)
CCG, which is the existing associate of Lucky Holdings, is incorporated in Australia. CCG
prepares financial statements in accordance with the Australian Accounting Standards.
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For consolidation purposes, CCG also prepares a group reporting package to Lucky Holdings
based on the HKFRSs.
On 1 January 2015, Lucky Holdings made a share exchange offer to all the other
shareholders of CCG to acquire a controlling interest in CCG, which would then become
a 100% owned subsidiary. Because CCG became the subsidiary of Lucky Holdings, the
management of CCG plans to prepare a complete set of HKFRSs financial statements starting
from the annual financial year ended 31 December 2015. These HKFRSs financial statements
would be distributed to the sole shareholder, which is Lucky Holdings.
Required:
Explain whether CCG is a first-time adopter of the HKFRSs under HKFRS 1 (Revised) First-
time Adoption of Hong Kong Financial Reporting Standards when it presents the complete set
of 2015 HKFRS financial statements; and list the presentation and disclosures requirements
that CCG should apply.
ANSWERS TO EXAM PRACTICE
QUESTION 1
(a) The Conceptual Framework defines an asset as a present economic resource controlled
by the entity because of past events. An economic resource is a right that has the
potential to produce economic benefits.
The definition uses the word potential, which indicates that it does not need to be
certain, or even likely, that the right will produce economic benefits. It is only necessary
that in at least one circumstance it would produce economic benefits, however remote
that occurrence might be. This means that a right can meet the definition of an
economic resource and, hence, can be an asset even if the probability of its producing
economic benefits is low.
Although the Conceptual Framework does not set a minimum probability threshold,
this does not necessarily mean that all rights with a low probability of future inflows
would be recognised as assets in financial statements.
The Conceptual Framework includes a section concerning recognition of asset.
The recognition criteria requires an entity to recognise an asset only if such recognition
provides users of financial statements with relevant information and a faithful
representation of the underlying transaction.
Uncertainty about the existence of an asset or a low probability of a flow of
economic benefits are noted as circumstances when recognition of a particular asset
might not provide relevant information.
For an asset to be recognised, it must also be measured. Most measures must be
estimated, which means they will be measured with some uncertainty. The Conceptual
Framework discusses the trade-off between providing a more relevant measure that
has a high level of estimation uncertainty and a measure that might be less relevant
but has lower estimation uncertainty. In limited circumstances, all relevant measures
may be subject to high measurement uncertainty, such that the asset should not be
recognised.
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If a high level of uncertainty exists, the most relevant information to users may be
about the potential magnitude of the item, the possible timing and the factors affecting
the probability. Such information shall be included within the notes to the financial
statements.
(b) The Conceptual Framework is a statement of generally accepted theoretical principles
that form the frame of reference for financial reporting.
It assists standard-setters in the development of new accounting standards and in
the review of existing standards.
Standard-setters have a common base for their decision-making, where possible,
would be consistent with the framework and would, therefore, be expected to meet
the objective of the framework, that is, to provide useful information to the users of
financial statements in making economic decisions.
It provides a basis for preparers in developing accounting policies for transactions
or events to which no specific or similar standard applies or when a standard allows a
choice of accounting policy.
It improves communication among practitioners and standard-setter.
It enhances the credibility of financial reporting and in turn helps to reduce
accounting’s vulnerability to political pressure.
QUESTION 2
The Conceptual Framework states that the statement of profit or loss is the primary source
of information about an entity’s financial performance for the reporting period.
The Conceptual Framework presumes that all income and expenses are presented in
profit or loss, unless the standard-setter has reason to decide that excluding certain income
and expenses, and instead including them in other comprehensive income (OCI) provides
more relevant and/or more faithfully represented information.
The assumption that all income and expenses are included in the statement of profit or
loss means that income and expenses included in OCI will normally be reclassified to profit
or loss in a future period. Only in exceptional circumstances may the standard-setter decide
that such income and expenses will not be reclassified to profit or loss, for example, if no
clear basis shows the reclassification will result in more useful information about an entity’s
profit or loss in a future period.
The Conceptual Framework does not specify when including particular items in OCI may
be appropriate, nor does it specify when subsequent reclassification may be appropriate.
These decisions will be made when individual standards are developed.
QUESTION 3
The Conceptual Framework identifies ‘faithful representation’ as one of the fundamental
qualitative characteristics of useful financial information. For information to represent
an economic phenomenon faithfully, that information must reflect the substance of the
economic phenomenon and not merely its legal form. The Conceptual Framework states that
derecognition of an asset normally occurs when the entity loses control of all or part of the
previously recognised asset. An entity controls an asset if it has the present ability to direct the
use of the asset and obtain the economic benefits that may flow from it.
51
FINANCIAL REPORTING
Under agreements 1 and 2, the trade receivables of HK$10 million are legally sold to
the bank. However, Entity Y should consider the economic substance of these transactions
when determining whether the trade receivables could be derecognised from the financial
statements.
For agreement 1, because the factoring is non-recourse, the bank has assumed full control
over the collectability of the receivables. Entity Y has no further access to the economic benefits
of the receivables as the initial payment of HK$8 million (80% × HK$10 million) is in full and final
settlement. The trade receivables of HK$10 million should be derecognised from the financial
statements of Entity Y.
For agreement 2, the bank has full recourse to Entity Y for a six-month period, so the
irrecoverable risk of the trade receivables is still with Entity Y. Furthermore, Entity Y retains the
right to receive further cash payments from the bank if the customers settle the receivables.
Consequently, the control of trade receivables does not pass to the bank and should not be
derecognised from the financial statements.
QUESTION 4
Although CCG has prepared a group reporting package in accordance with the HKFRSs in the
past for consolidation purposes, the group reporting package is an incomplete set of financial
statements.
Accordingly, in the year 2015, CCG is a first-time adopter when it presents the first annual
financial statements that include an explicit and unserved statement of compliance with
HKFRSs, and these financial statements are made available to CCG’s shareholders.
Though CCG is a first-time adopter in 2015 (i.e. the first HKFRS reporting period will be the
year ended 31 December 2015), the date of transition will be 1 January 2014.
The following presentation and disclosures are required to be considered:
• Three statements of financial position, that is, as of 31 December 2015, 31 December
2014 and 1 January 2014 (the date of transition) along with related notes as at the date of
transition;
• An explanation of the impact of its transition from Australian Accounting Standards to the
HKFRSs on the reported financial position, financial performance and cash flows of the
first-time adopter;
• Reconciliations of equity and reported total comprehensive income from previous GAAP
to the HKFRSs as of 1 January 2014 and 31 December 2014, together with explanations of
the reconciling items; and
• The correction of errors made under previous GAAP shall be identified separately in the
reconciliation.
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2
Financial Reporting Framework
and Standard for Small and
Medium-Sized Entities, and Financial
Reporting Standard for Other Private
Entities in Hong Kong
CHAPTER TOPIC LIST
2.1 Small and Medium-sized Entity 2.3.3 Benefits from Adopting the PE
Financial Reporting Framework Financial Reporting Framework
(SME-FRF) and Financial 2.3.4 Objective and Qualitative
Reporting Standard (SME-FRS, Characteristics
as revised on December 2021) 2.3.5 Elements
2.1.1 SME Financial Reporting 2.3.6 Recognition and Measurement
Framework (SME-FRF)
2.4 HKFRS for PE: Accounting,
2.1.2 Benefits from Adopting Presentation and Disclosure
the SME-FRF 2.4.1 PE Simplifications of HKFRS
2.1.3 SME Qualifying Criteria Accounting
2.2 SME Financial Reporting 2.4.2 PE Simplified Presentation
Standard (SME-FRS) 2.4.3 PE Simplified Disclosure
2.2.1 HKFRS Topics Not Covered
2.5 Comparison of the Three Hong
by SME-FRS Kong Financial Reporting
2.2.2 HKFRS Topics Addressed Frameworks: Full HKFRS,
by SME-FRS HKFRS-PE and SME-FRF
2.3 HKFRS for Private Entities (PE): and SME-FRS
Concepts and Principles 2.6 Current Developments
2.3.1 HKFRS Topics Not Covered
by HKFRS-PE
2.3.2 Private Entities: Criteria and
Eligibility
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LEARNING OUTCOMES
PRINCIPAL LO1: EXPLAIN AND APPLY THE FINANCIAL REPORTING FRAMEWORK IN HONG KONG
L01.01: D
escribe and explain the financial reporting framework for Small and
Medium-sized and other Private Entities in Hong Kong and the related implications for
business activities
1.01.04 Explain the condition under which an entity may adopt the Hong Kong Small and
Medium-sized Entity Financial Reporting Framework (SME-FRF) and the Hong Kong Small
and Medium-sized Entity Financial Reporting Standard (SME-FRS)
1.01.05 Summarise the requirements of the Hong Kong SME-FRF and the Hong Kong SME-FRS
1.01.06 Explain the conditions under which an entity may adopt the HKFRS for Private Entities
1.01.07 Summarise the requirements of the HKFRS for Private Entities
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OPENING CASE
SQUARE WARE
M ark and Wendy have operated a small unincorporated business, Square Ware (Square),
retailing homewares, such as kitchenware, small plastic goods, brushes, cleaning
equipment and a variety of knick-knacks that customers need to have inside their home.
They operate from one shop in a residential area and are looking to expand their business by
forming a company and taking out a bank loan.
To date, their accounting has been basic and the only applicable reporting obligation has
been the Inland Revenue Department requirement to complete an annual tax return. No other
formal financial reports have been prepared and, until now, the only people working in their
shop have been family members. With expansion, they will be looking to employ workers.
As part of the expansion of their business, Mark and Wendy have formed a private
company and would like advice on what financial reporting requirements they would need
to comply with, and how this may assist them with obtaining loan financing and income tax
reporting. Understandably, they wish to keep their compliance costs to a minimum.
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OVERVIEW
The Hong Kong Institute of Certified Public Accountants (HKICPA) has developed a stand-alone
framework and standard specifically applicable to Small and Medium-sized Entities (SMEs) to
address cost/benefit reporting considerations. The SME Financial Reporting Framework (SME-FRF)
and SME Financial Reporting Standard (SME-FRS), known as (SME-FRF and SME-FRS, revised
December 2021), are recognised by the Companies Ordinance (CO) as an appropriate financial
reporting framework for qualifying entities and accepted for income tax and banking purposes.
The HKICPA has also promulgated the Hong Kong Financial Reporting Standard for Private
Entities (HKFRS-PE) (revised March 2022), which is a body of Generally Accepted Accounting
Principles (GAAP) converged with the International Financial Reporting Standards (IFRS) for
SMEs issued by the International Accounting Standards Board (IASB).
Both sets of requirements for private entities are based on the principles of the IFRS but are
simplified in terms of requirements when compared to HKFRS.
Some entities may qualify to apply the SME-FRF and SME-FRS or the HKFRS-PE. To be
able to apply SME-FRF and SME-FRS, a company must qualify for a CO exemption (set out in
Section 359 of the CO) from other forms of reporting. The grounds for exemption are set out in
the following text.
To apply the HKFRS-PE, a company cannot be publicly accountable (or engaged in certain
types of activity, such as banking) or else it must apply the full HKFRS.
In the SME and PE scenarios, the company must qualify as a private company (see the
following text).
The requirements in SME-FRS are, depending on the circumstances of the company,
potentially less onerous than those in HKFRS-PE, which in turn are potentially less onerous
than those in HKFRS. This generally provides private company preparers with a desire to meet
the qualifying criteria for SME-FRS unless they need general purpose financial reports for their
external users or simply wish to follow the HKFRS-PE or the HKFRS.
The CO reporting exemption for qualifying private companies, and some companies limited
by guarantee, relieves directors from reporting certain aspects otherwise required in directors’
reports and certain financial reporting requirements. But the reporting exemptions are
available on the condition that the financial statements comply with the applicable standard
specified by the HKICPA, namely, SME-FRS.
If the reporting exemption conditions are not met, the entity concerned will need to comply
with the full requirements applicable to a company of its type, both for director reporting and
financial reporting. This will mean for private companies that the HKFRS-PE will be applicable
(unless the entity chooses to apply the full HKFRS).
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The CO exempts the financial statements of an entity qualifying for SME-FRF and SME-FRS
HKFRS-PE
20 from needing to give a true and fair view. The auditor’s report is a compliance report that
states, in normal circumstances, that the financial statements have been prepared in
PIN 600.1 accordance with SME-FRS. In the case of an entity reporting under the HKFRS and HKFRs-PE, the
normal unmodified audit report is expressed as ‘presented fairly’ or is ‘true and fair’ in
accordance with HKFRS or HKFRS-PE.
2 . 1 SMALL AND MEDIUM-SIZED ENTITY
FINANCIAL REPORTING FRAMEWORK
(SME-FRF) AND FINANCIAL REPORTING
STANDARD (SME-FRS, AS REVISED ON
DECEMBER 2021)
This section provides a summary of the framework that provides for simplified Hong Kong
financial reporting requirements available to qualifying Small and Medium-sized Entities (SMEs).
Those entities will be certain private companies, or companies limited by guarantee, who avail
themselves of the ‘reporting exemption’ under the CO.
2.1.1 SME Financial Reporting Framework (SME-FRF)
This SME Financial Reporting Framework (SME-FRF) sets out the broad objectives and basis
of accounting on which the SME Financial Reporting Standard is established. The nature
of the SME financial statement users, underlying reporting assumptions and qualitative
characteristics, financial statement elements, recognition and measurement are specified in the
SME-FRF, together with qualifying criteria and the method of transitioning into SME financial
reporting.
2.1.1.1 Users of SME-FRF and SME-FRS
Users of the SME-FRF and SME-FRS financial statements generally include existing and
potential:
• Private investors;
• Employees;
• Lenders;
• Suppliers and other trade creditors;
• Customers; and
SME-FRF 4 • Governments and their agencies.
Though this list of users may seem similar to the full HKFRS, an important distinction is
that SME financial reports are not intended to serve a public accountability function. Often, the
users (such as banks and taxation authorities) can seek additional information if needed.
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Though management is not listed as a user in the preceding bullet points, in SMEs, the
financial statements will often be a primary source of information for management too.
Management is often less well-placed to have tailored information prepared internally as
compared to a public company.
2.1.1.2 Underlying Assumptions of SME-FRF and SME-FRS
The two underlying assumptions are accrual and going concern. Financial statements are
prepared on the accrual basis of accounting, bringing to account revenues, expenses, assets,
liabilities and equity and not just cash and cash transactions.
In addition, financial statements are normally prepared on the assumption that an entity is
SME- a going concern (able to meet its debts as and when due) and is expected to continue to be for
FRF 6 the foreseeable future.
2.1.1.3 Qualitative Characteristics of SME-FRF and SME-FRS
Qualitative characteristics are the attributes that make the information provided in financial
statements useful to users for making their economic decisions. There are four principal
characteristics:
1. Understandability: Users are able to understand the meaning of the financial statements;
2. Relevance: Information is pertinent to the decisions users seek to make;
3. Reliability: Information is free from material error and bias and faithfully represents
what is said to represented. Considerations of substance over form, prudence,
neutrality and completeness will come into assessing reliability; and
SME- 4. Comparability: Information needs to be consistently prepared and presented over time and
FRF 7 between entities. Where changes are needed in information, changes should be explained.
Standard-setters, regulators, preparers and auditors need to make judgements about
what should be included in financial statements to serve the needs of users. Implicit in those
judgements is a need to balance the costs of preparing and presenting those statements
against the benefits to users. When a standard-setter or regulator sets down a requirement
that is material to an entity, the preparer cannot over-ride the requirement on the basis
that costs are too great. The judgement of the standard-setter or regulator will prevail. But
preparers must decide many matters about possible voluntary disclosures and must choose
between permissible accounting policies based on an assessment of costs versus benefits.
Illustrative Example 1
Square is an SME. It uses the historical cost basis to account for the property used as
its office. The cost of the property is traceable to the transaction through which the
property was acquired. There is no ambiguity as to what that cost is. And Square cannot
change the measurement and assert that the basis is still historical cost. Such a cost can
be said to be reliably measured. However, if Square wants to borrow funds by using this
property as collateral, the historical cost is normally of limited relevance to the lender’s
assessment of how secure the loan will be should the borrower default. For the lender,
the performance of the entity and the fair value of the property will be the relevant
measures even though fair value may involve estimation. If Square uses the historical
cost, the lender needs to understand its limitations as a measure of collateral. In such
situations, some additional information may be demanded by the lender beyond what
can be derived from Square’s financial statements.
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2.1.1.4 Elements of Financial Statements
The SME-FRF and SME-FRS identify the following financial statements elements that are broadly
comparable to those discussed in Chapter 1:
• An ‘asset’ is a resource the entity controls as a result of past events and from which
future economic benefits are expected to flow to the entity.
• 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.
• ‘Equity’ is the residual interest in the assets of the entity after all its liabilities have
been deducted.
• ‘Income’ encompasses revenue and gains. It includes increases in economic benefits
during the accounting period in the form of inflows or enhancements of assets as well
as decreases of liabilities that result in increases in equity, other than those relating to
contributions from equity participants.
SME-FRF • ‘Expenses’ encompass losses and those expenses that arise during the ordinary
10–14 activities of the entity. Expenses are decreases in economic benefits.
2.1.1.5 Recognition and Measurement under SME-FRF and SME-FRS
In coming to the SME-FRS, the standard-setters have largely kept to historical cost. This basis
may be combined with other measurement bases for certain specified items, as referred to in
the SME-FRS.
Under the historical cost basis employed:
• Assets are recorded at the amount of cash or cash equivalents paid (or the fair value of
the other consideration given) to acquire them at the time of their acquisition; and
• Liabilities are recorded at the amount of proceeds received in exchange for the
obligation or, in some circumstances (e.g. where the obligation doesn’t relate to
proceeds received as in the case of income taxes and liabilities for penalties incurred),
at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in
the normal course of business.
SME-FRF Assets are not be revalued nor should future cash flows be discounted in the measurement
17–18 of assets and liabilities except when the SME-FRS requires or permits.
2.1.2 Benefits from Adopting the SME-FRF
The benefits of adopting the SME-FRF are as follows:
• It is a recognised basis of accounting, enhancing the comparability of financial
statements in SMEs. The financial reporting of SMEs is more standardised;
• Because the financial statements of SMEs is standardised, it can improve confidence of
the users in the accounts of SME because they will have a recognised benchmark for
the reporting;
• The SME-FRF is simplified from the full HKFRS (as shall be explained in Section 2.3
on HKFRS-PE), and hence, it makes the accounting requirements less complex for
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qualifying SMEs. For example, the SME-FRF excludes those topics and disclosure
requirements irrelevant to the typical SME, such as earnings per share and interim
financial reporting requirements. Even though the SME-FRF adopts the fundamental
principles of the full HKFRS, it reduces the cost and effort to produce the financial
statements by removing several accounting requirements and options from the full
HKFRS; and
• Because the SME-FRF and SME-FRS are largely predicated on the historical cost basis of
accounting (a basis generally easier to understand than the mixed measurement model
of the full HKFRS), the development and maintenance of its framework and standard do
not need to address the complications of measuring fair value and dealing with other
advanced topics. Hence, the SME-FRS does not undergo constant addition and change
to keep pace with developments in the full HKFRS, and this further assists in avoiding
additional compliance costs for qualifying entities.
But the limited approach of the SME-FRS does not provide users with information that is
mandatory for publicly accountable entities. Those requirements have been carefully prepared
having regard to user needs and are used widely (including by relatively small entities).
However, the HKFRS are not designed to be applied when a transaction or event is not covered
by the SME-FRS. That is, they are not what have been termed ‘fall-back’ provisions. Management
needs to exercise its judgement in those circumstances having regard to the SME-FRF and to
the requirements of other parts of the SME-FRS.
Nevertheless, management of SMEs should carefully consider whether, in their
circumstances, the needs of their users go materially beyond the typical requirements of
the SME-FRS. For example, a small private entity has commonly entered, inadvertently or
otherwise, into an exotic derivative which, if unreported, could severely impact users’ decision
making. Management will need to consider, if it is atypical of SMEs in a particular regard,
whether voluntary disclosures are needed and whether any cautions need to be included in
their financial statements.
2.1.3 SME Qualifying Criteria
Only certain types of companies can qualify for the reporting exemption from applying the
full HKFRS or HKFRS-PE under the ‘new CO’. (The current CO has existed for some time but
‘new CO’ is used as an abbreviation and to imply change did occur with its introduction.) At a
minimum, in accordance with Section 359 of the new CO, these companies (or groups) must be
private companies (or groups) or companies (or a group of companies) limited by guarantee.
As outlined in the following, size tests and/or shareholder approval requirements may be
required to be met.
2.1.3.1 Exclusions from Exemptions from Full HKFRS
In Section 2.1.3.3, which entities will qualify for the reporting exemption may not be
straightforward. Let us simplify the identification of companies that might apply the SME-FRS by
listing those entities that will be ineligible for the exemption:
• Public companies; and
• Private companies that:
°° Carry on a banking business and hold a valid banking licence;
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°° By way of trade or business (other than banking business) accept loans of money
at interest or repayable at a premium, other than on terms involving the issue of
debentures or other securities;
°° Are corporations licenced under Part V of the Securities and Futures Ordinance
(Cap. 571) to carry on a business in any regulated activity within the meaning of that
Ordinance; or
°° Carry on any insurance business, otherwise than solely as an agent.
If a private company is the holding company of a group of companies, it will be excluded
from the exemption if any company in the group falls under the categories shown above for
private companies.
Companies that do not satisfy the definition of a private company will be excluded.
According to Section 11 of the new CO, a company that is not limited by a guarantee is a
‘private company’ if its articles:
• Restrict a member’s right to transfer shares;
• Limit the number of its members to 50; and
• Prohibit any invitation to the public to subscribe for any shares or debentures of
the company.
According to Section 382 of the new CO, if a private company breaches any of the preceding
criteria at any time during the financial year, then it is required to prepare its financial
statements as if it were a public company, that is, it will no longer qualify for the reporting
exemption from applying the full HKFRS unless the Court allows otherwise.
In principle, the preceding restrictions on entities availing themselves of the exemption
from the HKFRS are driven by the concept of public accountability.
2.1.3.2 Types of Companies Qualifying for SME-FRS
We turn now to the types of companies that may be eligible for exemption and so be able to
use the SME-FRF and SME-FRS. Those entities may be private companies, private companies
limited by guarantee or holding companies in groups of companies that are a mixture of those
types of companies.
To be eligible, these types of companies may need to meet criteria that relate to
shareholder agreement to not applying the HKFRS (or, as will be explained in Section 2.3,
HKFRS-PE), or to achieve limited shareholder agreement and/or meet size tests. If the
requirements are not met, again the companies concerned would not be able to enjoy the
exemption from applying the full HKFRS.
For ease of understanding, the following discussion separates consideration of qualifying
for SME-FRS into:
• Individual companies; and
• Companies that are parts of private companies.
Individual companies
Individual companies can consist of:
• ‘Eligible’ private companies;
• Smaller private companies; and
• Companies limited by guarantees.
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‘Eligible’ private companies
The most straightforward example of an eligible private company is a stand-alone private
company (i.e. not part of a group and not limited by guarantee) and for which 100% of
shareholders agree, each year, with being exempt from the full HKFRS. There is no size test for
such a company. It can simply adopt the HKFRS-PE (covered in Section 2.3) or SME-FRS.
For some larger stand-alone private companies, it may not be practicable to achieve 100%
agreement from shareholders. For these companies, the size criteria will apply, providing at
least 75% of all the members pass a resolution at a general meeting that the company is to fall
within the reporting exemption for the financial year and provided that none of the members
holding the remaining voting rights in that company have voted against the resolution.
The size criteria applicable to this category (larger eligible private companies) are that the
private company must not exceed any two of the following:
• Total annual revenue of HK$200 million;
• Total assets of HK$200 million at the end of the reporting period; and
• 100 employees.
Smaller private companies
For smaller private companies, the requirement for shareholder agreement falls away and
sizes become the determining criteria. The private company must not exceed any two of the
following:
• Total annual revenue of HK$100 million;
• Total assets of HK$100 million at the end of the reporting period; and
• 100 employees.
Companies limited by guarantees
The remaining category of individual entities to consider is the private company limited by
guarantee. According to Section 9 of the new CO, a company is ‘limited by guarantee’ under the
new CO if:
• It does not have a share capital; and
• Its articles limit the liability of its members to the amount its members undertake, by
those articles, to contribute to the assets of the company if it is wound up.
Here, the company must be ‘small’, with a total annual revenue not exceeding HK$25
million. It need not obtain member agreement to apply the SME-FRS and SME-FRS.
Groups of private companies
We have previously discussed those exclusions in which holding companies and certain
companies within groups will generically be ineligible for exemption from applying the
full HKFRS.
Let us turn to examine the criteria for eligibility that will enable exemption for the following
types of group:
• For a group of ‘eligible’ companies;
• For a group of smaller private companies (which may include non-Hong Kong body
corporates);
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• For a group of smaller private companies but where the companies are limited by
guarantee; and
• For a group that is mixed (being a group comprising a mix of (i) one or more small and/
or eligible private companies, and (ii) one or more small guarantee companies) that may
include non-Hong Kong body corporates.
Groups of ‘eligible’ private companies
The criteria here are like those for a stand-alone private company for which 100% agreement of
shareholders each period is not practical. At a general meeting, at least 75% of all the members
must pass a resolution that the company is to fall within the reporting exemption for the
financial year, and none of the members holding the remaining voting rights in that company
are to have voted against the resolution:
• Each company in the group must meet either the size test for a small private company
or for a larger ‘eligible’ private company;
• Each non-Hong Kong body corporate in the group (if any) would need to qualify as a
small private company or a larger ‘eligible’ private company for the financial year had it
been incorporated under the new CO on the basis of its size; and
• The aggregate amounts for the group in total must not exceed two out of three of the
size tests for larger ‘eligible’ private companies
Groups of smaller entities
There is no requirement for shareholder agreement for these groups, but:
• Each company in the group must qualify as a small private company;
• Each non-Hong Kong body corporate in the group (if any) would have been qualified
as a small private company for the financial year had it been incorporated under the
new CO; and
• The aggregate amounts for the group must not exceed two out of three of the size tests
for small private companies.
Groups of smaller companies limited by guarantee
This category comprises a group of small companies each limited by guarantee and that
may include non-Hong Kong body corporates. As for other smaller private companies, no
shareholder approval is required, but:
• Each company in the group must qualify as a small company limited by guarantee;
• Each non-Hong Kong body corporate in the group (if any) would have been qualified as
a small company limited by guarantee for the financial year had it been incorporated
under the new CO; and
• The aggregate annual revenue of the group must not exceed HK$25 million.
‘Mixed’ groups
Mixed groups are those comprising a mix of one or more small and/or eligible private
companies and of one or more small guarantee companies. The group may include non-Hong
Kong body corporates.
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For a mixed group which does not exceed the size limits of a group of small private
companies or small guarantee companies, approval from members is not required under
the new CO.
For a mixed group with larger ‘eligible’ private company within the group, at a general
meeting, at least 75% of all the members of the holding company of the group must pass a
resolution that the holding company is to fall within the reporting exemption for the financial
year, and none of the members holding the remaining voting rights in the holding company
must have voted against the resolution.
If the holding company in the mixed group is a small private company, the aggregate
amounts for the mixed group in total must not exceed two out of three of the size tests
previously shown for a group of small private companies.
If the holding company in the mixed group is an ‘eligible’ private company, the aggregate
amounts for the mixed group in total must not exceed two out of three of the size tests
previously shown for a group of larger ‘eligible’ companies.
If the holding company in that mixed group is a small guarantee company, the aggregate
annual revenue of the mixed group must not exceed HK$25 million.
2.1.3.3 Summary Table of Qualifying Criteria/Size Tests
The preceding requirements for the financial reporting exemption from applying full HKFRS are
summarised in Exhibit 2.1 for ready reference.
Categories Size test Approval from Section
(by number) shareholders reference
1. An ‘eligible’ private No size test is required 100% written approval SME-FRF
company that from shareholders is Para 43
has no subsidiary required for each year
and is not a
subsidiary of
another company
(If the private company
also qualifies under
category 2 below,
approval from
shareholders wil not
be required)
2. Larger ‘eligible’ The private company must not At a general meeting, SME-FRF
private company exceed any two of the following: at least 75% of all the Paras
• Total annual revenue of HK$200 members must pass 38–39, 42
million a resolution that the
company is to fall
• Total assets of HK$200 million at
within the reporting
the end of the reporting period
exemption for the
• 100 employees financial year, and
none of the members
holding the remaining
voting rights in that
company vote against
the resolution
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Categories Size test Approval from Section
(by number) shareholders reference
3. Small The private company must not Approval from SME-FRF
private company exceed any two of the following: shareholders is not Paras
• Total annual revenue of HK$100 required under the 36–37
million new CO
• Total assets of HK$100 million at
the end of the reporting period
• 100 employees
4. Small company The total annual revenue of the small Approval from SME-FRF
limited company limited by guarantee must members is not Paras
not exceed HK$25 million required under the 34–35
by guarantee new CO
5. A group of • Each company in the group At a general meeting, SME-FRF
larger ‘eligible’ must meet the size test of small at least 75% of all Paras
private company or larger the members of the 38–39, 42
companies which ‘eligible’ private company holding company of
may include • Each non-Hong Kong body the group must pass
non-Hong Kong corporate in the group (if any) a resolution that the
would have been qualified as holding company is to
body corporates
a small private company or a fall within the reporting
larger ‘eligible’ private company exemption for the
for the financial year had it been financial year, and
incorporated under the new CO none of the members
on the basis of its size holding the remaining
voting rights in the
• The aggregate amounts for the
holding company vote
group in total must not exceed
against the resolution
two out of three of the size
tests for larger ‘eligible’ private
companies (refer to preceding
category 2)
6. A group of • Each company in the group must Approval from SME-FRF
small private qualify as a small private company shareholders is not Paras
• Each non-Hong Kong body required under the CO 36–37
companies that
corporate in the group (if any)
may include would have been qualified as
non-Hong Kong a small private company for
body corporates the financial year had it been
incorporated under the new CO
• The aggregate amounts for the
group must not exceed two
out of three of the size tests for
small private companies (refer to
preceding category 3)
7. A group of small • Each company in the group Approval from SME-FRF
companies must qualify as a small company members is not Paras
limited by guarantee required under the 34–35
each limited by new CO
• Each non-Hong Kong body
guarantee that corporate in the group (if any)
may include would have been qualified as
non-Hong Kong a small company limited by
guarantee for the financial year
body corporates
had it been incorporated under
the new CO
• The aggregate annual revenue
of the group must not exceed
HK$25 million
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Categories Size test Approval from Section
(by number) shareholders reference
8. Mixed group • If the holding company in • For a mixed SME-FRF
(being a group that mixed group is a small group that does
private company, the aggregate not exceed the
comprising a amounts for the mixed group in size limits of a
Paras 39A,
mix of (i) one 42
total must not exceed two out of group of small
or more small three of the size tests for a group private companies
of small private companies (see (category 6) or
and/or large
preceding category 6) small guarantee
eligible private companies
• If the holding company in that
companies and mixed group is a large eligible (category 7),
(ii) one or more private company, the aggregate approval from
amounts for the mixed group in members is not
small guarantee
total must not exceed two out of required under the
companies) that new CO
three of the size tests for a group
may include of larger ‘eligible’ companies (see
non-Hong Kong preceding category 5)
body corporates • If the holding company in that • For a mixed
mixed group is a small guarantee group with larger
company, the aggregate annual ‘eligible’ private
revenue of the mixed group company within
must not exceed HK$25 million the group, at a
general meeting,
at least 75% of
all the members
of the holding
company of the
group must pass a
resolution that the
holding company
is to fall within
the reporting
exemption for
the financial year;
and none of the
members holding
the remaining
voting rights in the
holding company
vote against the
resolution.
EXHIBIT 2.1 Qualifying criteria/size tests for applying SME-FRS
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Illustrative Example 2
Square is a large ‘eligible’ SME (see preceding category 2) and is currently using the
full HKFRS in preparing its financial statements. It wants to prepare simplified financial
statements. Five shareholders are in Square, and each of them carries the same voting
right. An extraordinary general meeting was held to discuss the adoption of the SME-FRF
and SME-FRS. Only four members attended the meeting. Three of them approved
the proposal and one of them abstained from voting. The one who did not attend the
meeting did not vote by proxy. Therefore, only 60% of the members approved the
proposal, and hence, the resolution could not be passed. Square is still required to
prepare its financial statements under the full HKFRS even though no member has voted
against the resolution even if it meets the size tests for a small private company. This
brings home how directors and shareholders must understand the requirements.
Illustrative Example 3
Square is a large private holding company in preceding category 5. It now has two
subsidiaries, Rectangle and Triangle, which are also private companies. None of the three
companies would satisfy the size tests for the SME-FRS. Square is currently adopting
the full HKFRS in preparing its consolidated financial statement. The management of
Square wanta to adopt the SME-FRF and SME-FRS in preparing this period’s consolidated
financial statements to reduce the cost and effort of such preparation. Therefore, an
extraordinary general meeting has been held, and a resolution is passed by all the
shareholders of Square regarding this issue. Square can prepare its consolidated
financial statements for the year by using the SME-FRF and SME-FRS, and obtaining
the approval from the Rectangle and Triangle shareholders is unnecessary. No size
test is needed in such a situation, but in future years, that approval would also need to
be forthcoming. (Square could also have adopted the HKFRS-PE without shareholder
approval.)
Key Learning Points
The SMS-FRF and SME-FRS were developed specifically to reduce the costs of complying
with the full HKFRS for those entities that comply with certain criteria (involving
shareholder agreement and/or meeting size tests).
The main simplification in the SME-FRF is the adoption of the historical cost basis of
accounting. A significant benefit for preparers under the SME-FRF is that the standard is
subject to less frequent and less significant change over time than when compared with
the full HKFRS.
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Knowledge Check Questions
Question 1
Identify which of the following bodies issues financial reporting standards applicable to
small and medium-sized entities in Hong Kong.
A Hong Kong Legislative Council (Companies Ordinance)
B Hong Kong Institute of Certified Public Accountants
C Companies Registry
D Inland Revenue Department
Question 2
Identify which two of the following objectives are less well served by the SME-FRS when
compared to the full HKFRS:
A To optimise the cost of preparing financial statements
B To prepare financial statements for income tax reporting
C To report to investors and potential investors
D To report to lenders and potential lenders
Question 3
Explain how a private company that sees itself as large, and which is not a subsidiary of
another company and has no subsidiaries, could apply the SME-FRS. It expects that 100%
of its shareholders would agree to do so.
Question 4
Identify which of the following situations would permit an otherwise qualifying small
private company to apply the SME-FRS in its financial reporting:
A Revenue HK$110 million, Assets HK$90 million, 90 employees, 80% shareholder approval
B Revenue HK$90 million, Assets HK$110 million, 90 employees, 100% shareholder approval
C Revenue HK$90 million, Assets HK$105 million, 110 employees, 70% shareholder approval
D Revenue HK$110 million, Assets HK$110 million, 90 employees, 60% shareholder
approval as provided for in the company’s articles
2 . 2 SME FINANCIAL REPORTING
STANDARD (SME-FRS)
This section summarises the requirements set out in the Small and Medium-sized Entities
Financial Reporting Standard (SME-FRS). The learning objectives for this section do not require a
detailed knowledge of individual requirements set down in the SME-FRS; rather they are aimed
at an appreciation of the nature of the requirements and when they can be applied.
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The SME-FRS is issued by the Council of the Hong Kong Institute of Certified Public
Accountants and recognised under the CO. The standard is briefer and simpler than the full
HKFRS and HKFRS-PE.
The following description of the 22 sections comprising the SME-FRS is not intended to be
complete; instead, it provides an overview of the types of requirements included, identifying
which are distinctive when compared to the HKFRS.
Section 2.4 compares HKFRS-PE and HKFRS.
In Section 2.5, the comparisons are brought together for the HKFRS, HKFRS for Private
Companies and SME-FRS.
Despite the differences in the three sets of requirements, a good deal of commonality
exists, especially for smaller entities not engaged in complex transactions.
Readers are cautioned that the following descriptions and in Sections 2.4 and 2.5 are not
substitutes for reading the SME-FRS and HKFRS-PE.
When the phrase ‘the accounting is conventional’ is used, it means the accounting is largely
the same in the SME-FRS and HKFRS. In a few cases (e.g. accounting for leases and accounting
for revenue from contracts with customers), conventional accounting is akin to the HKFRS
before recent changes. These instances are noted in the following.
2.2.1 HKFRS Topics Not Covered by SME-FRS
A distinctive feature of SME-FRS is that the sections of which it is comprised do not include
equivalents to:
• HKFRS 2 Share-based Payments
• 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 12 Disclosure of Interests in Other Entities
• HKFRS 13 Fair Value Measurement
• HKFRS 14 Regulatory Deferral Accounts@
• HKFRS 15 Revenue from Contracts with Customers*
• HKFRS 16 Leases*
• HKFRS 17 Insurance Contracts*
• HKAS 19 Employee Benefits
• HKAS 26 Accounting and Reporting by Retirement Benefit Plans@
• HKAS 29 Financial Reporting in Hyperinflationary Economies@
• HKAS 32 Financial Instruments: Presentation
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• HKAS 33 Earnings per Share
• HKAS 34 Interim Financial Reporting
• HKAS 40 Investment Property
• HKAS 41 Agriculture
@
These standards are not within scope of Module 11.
*
Instead of HKFRS 15 and 16 in the preceding list, past HKAS standards (HKAS 18 Revenue and HKAS 17
Leases) are used.
Old HKAS 11 Construction Contracts, which has been subsumed in HKFRS 15, is also applied.
Some section names are slightly different to those used in the HKFRS, but the sections
address the topics covered therein.
The first point to observe about the preceding list of omitted standards is that they cover
topics not commonly confronted by SMEs. The second is that some topics, which may be faced
by some SMEs are, nevertheless, omitted because of the costliness of compliance. The financial
instruments requirements (HKFRS 7 and 9, and HKAS 32) are the prime examples. The third
observation is that where conventional accounting has some history in practice, it has not been
upset by the introduction of new standards, for example, HKFRS 15 and HKFRS 16.
As previously indicated, if the SME-FRS does not cover an event or transaction,
management will need to apply judgement to develop an accounting policy. There is no
requirement to default to (fall-back to) the full HKFRS.
2.2.2 HKFRS Topics Addressed by SME-FRS
Under each of the following section headings that are covered, an indication is given as to
whether the requirements are largely conventional or distinctive. Not all differences are noted.
Section 1 Presentation of Financial Statements
A statement of cash flows is optional. If presented, it must comply with Section 22 of
the SME-FRS.
Section 2 Accounting Policies, Changes in Accounting Estimates and Errors
Selecting accounting policies: The standards in the SME-FRS provide a context within which
management will need to choose any accounting policy choices open to it. For example, the
focus on use of the historical cost basis would generally mean that fair value options that exist
in the HKFRS would not be chosen without a reason specific to the entity.
Section 3 Property, Plant and Equipment (PPE)
Initial and subsequent recognition and measurement:
• Initial measurement is at cost; and
• Subsequent measurement: After initial recognition, PPE is either carried at cost
less accumulated depreciation or is at the appropriate amount after impairment.
Impairment of PPE is covered under Section 9.
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Nevertheless, exchanges of PPE are measured at fair value, including exchanges of similar
items, unless the exchange transaction lacks commercial substance or the fair value of neither
the asset received nor the asset given up can be measured reliably.
Section 4 Intangible Assets (other than goodwill)
Intangible assets are measured at cost/amortised cost and are not revalued.
There is a rebuttable presumption that the useful life of a depreciable intangible asset
will not exceed 10 years from the date when the asset is available for use. Amortisation
commences when the asset is available for use. An intangible asset acquired in a business
combination is recognised if its fair value is readily apparent or otherwise can be measured
reliably without undue cost.
Section 5 Leases
Lease accounting has not been revised to be in accord with the property rights approach now
being introduced through HKFRS 16. Rather, it is based on the old HKAS 17 (quasi purchase)
approach under which a lease is classified as a finance lease if it transfers substantially all risks
and rewards incidental to ownership, such as when the lease covers the major part of the
asset’s economic life or the present value of lease payments is substantially all of the asset’s
fair value. All other leases are classified as operating leases. A lease of land and buildings is split
into land and building elements.
The accounting of lessees for lease assets and liabilities parallels accounting for fixed assets
and mortgage loans, but some use of values is needed. For example, a lease is classified as a
finance lease if it transfers substantially all risks and rewards incidental to ownership (e.g. when
the lease covers the major part of the asset’s economic life or the present value of lease
payments is substantially all of the asset’s fair value). In the case of a lessee, a finance lease
asset and liability are recognised at the lower of the present value of minimum lease payments
and the fair value of the asset.
For lessors, the accounting again parallels that set down in the old HKAS 17, with limited
reductions in HKAS 17 disclosures for finance and operating leases.
Finance leases are to be brought to account as receivables and measured at the net
investment in the lease. That investment is determined by discounting the minimum lease
payments at the interest rate implicit in the lease and by allowing for any unguaranteed
residual. Income on finance leases should reflect a constant periodic rate on the net investment
by the lessor.
For operating leases, the lessor accounts for the assets subject to the lease (not the
receivable required for finance leases). This includes accounting for depreciation of the assets.
Operating lease rentals are then accounted for as periodic income, usually on a straight-line
basis unless some other basis is more representative of the pattern in which the benefit of the
leased asset is diminished.
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Section 6 Investments
The cost model is to be applied in accounting for investments in subsidiaries in company-level
(separate) financial statements and in accounting for other investments in securities, whether
in company-level financial statements or consolidated financial statements, including associates
and joint ventures.
Section 7 Inventories
The accounting for inventories is conventional.
Section 8 Construction Contracts
The accounting is conventional and has not been adjusted for the HKFRS dealing with revenue
HKFRS 15 from contracts with customers.
Section 9 Impairment of Assets
The accounting is conventional.
Section 10 Provisions, Contingent Liabilities and Contingent Assets
The accounting is conventional.
Section 11 Revenue
The accounting is conventional and has not been adjusted for the HKFRS 15. Revenue is
measured at the fair value of the consideration received/receivable.
Section 12 Government Grants and Other Government Assistance
The accounting is conventional.
Section 13 Borrowing Costs
The accounting is conventional.
Section 14 Income Taxes
Current tax for current and prior periods should, to the extent unpaid, be recognised as a
liability. If the amount already paid related to current and prior periods exceeds the amount
due for those periods, the excess should be recognised as an asset. Deferred tax liabilities or
assets (i.e. the amounts of income taxes payable or recoverable in future periods in respect of
taxable temporary differences or deductible temporary differences and the carryforward of
unused tax losses and tax credits) should not be recognised.
Section 15 The Effects of Changes in Foreign Exchange Rates
The accounting is conventional.
Section 16 Related Party Disclosures
The accounting is conventional.
Section 17 Events after the End of the Reporting Period
The accounting is conventional.
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Section 18 Business Combinations and Goodwill
Business combinations are accounted for when applying the purchase method, recognised
at acquisition date as the aggregate of the fair values of assets given, liabilities incurred or
assumed and equity instruments issued by the acquirer in exchange for control of the acquiree.
Goodwill should be amortised on a systematic basis over the best estimate of its useful life.
There is a rebuttable presumption that the useful life of goodwill will not exceed five years from
initial recognition.
Section 19 Consolidated and Company-level Financial Statements
The accounting is conventional.
Section 20 Investments in Associates
Benchmark treatment: Investments in all associates are accounted for under the cost model
in accordance with Section 6 Investments, irrespective of whether the investor is presenting
company-level financial statements or consolidated financial statements.
Allowed alternative treatment for an investor that presents consolidated financial
statements under Section 19: Investments in associates are accounted for in the consolidated
financial statements using the equity method of accounting.
Section 21 Interests in Joint Ventures and Other Forms of Joint Arrangements
Benchmark treatment: Investments in all joint ventures accounted for under the cost model
in accordance with Section 6 Investments, irrespective of whether the investor is presenting
company-level financial statements or consolidated financial statements.
Allowed alternative treatment for an investor that presents consolidated financial
statements under Section 19: Investments in joint ventures in the consolidated financial
statements are accounted for using the equity method of accounting.
Section 22 Cash Flow Statement (optional)
As indicated in Section 1, if an entity chooses to present a cash flow statement, then it must
comply with this section, which is conventional.
Key Learning Point
The SME-FRS comprises 22 sections of requirements for qualifying entities’ financial
reporting. The requirements are prescriptive in nature and largely follow the historical
cost basis set out in the SME-FRF. The intention with this approach, while standardising
the requirements, is to reduce the costs of compliance and to minimise the necessity to
change the requirements.
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Apply and Analyse 1
Mark and Wendy from Square have been told that if they adopt the SME-FRF, their
accounting for the acquisitions of Rectangle and Triangle will not result in their
consolidated financial statements showing enough assets to justify the financing they are
seeking from their bank to further expand their business. They have also been told that
those statements will include a large goodwill number, from the acquisitions, that the
banks will ignore.
The major reason for acquiring Rectangle and Triangle was that each controlled a
product line that complemented Square’s range. Mark and Wendy had invested a lot of
time, with some professional assistance, in looking at the value of those product lines they
acquired as they were critical to the acquisition decision.
Mark and Wendy ask whether they should opt for the full HKFRS to improve their
financial reporting and their chances of obtaining the desired funding.
Analysis
To assist Mark and Wendy, it will be necessary to untangle misconceptions about how
the bank will evaluate their financial position and performance and how the accounting
standard for the SME-FRS would apply to their acquisitions of Rectangle and Triangle.
The bank will focus on the cash flows of Mark and Wendy’s business, including those
from Rectangle and Triangle, to assess whether those cash flows can bear loan repayments
and further financing expenses. Those cash flows will be the preferred source for the bank
of Square repaying the loan and the interest.
The bank will also be concerned with how they can secure the loan they are making
to guard against the possibility that Mark and Wendy might be unable to service the
loan. Though Mark and Wendy consider the intangible rights of Rectangle and Triangle
valuable, will the rights, if being a significant proportion of the group’s assets, be worth
anything if the Square group cannot operate them? Could they be readily sold to others
at a reasonable price? The bank will also look at the other business and personal assets of
Mark and Wendy to see if they might be used as security. In relation to Mark and Wendy’s
personal assets, they will need to ensure they do not effectively surrender the value of
owning a limited liability group of companies.
Turning to the misconceptions about the financial reporting, the SME-FRS does not
preclude the use of fair value to initially recognise intangible assets acquired in a business
combination. An intangible asset acquired in a business combination is to be recognised if
its fair value is apparent or otherwise can be measured reliably without undue cost. But it
does not envisage revaluation of such assets after initial recognition. This does not matter
in Mark and Wendy’s situation as they have only recently acquired Rectangle and Triangle,
and they have the details to support a valuation at fair value.
You should advise Mark and Wendy that well-prepared and presented financial
statements that comply with a recognised accounting framework will indicate to parties,
such as the bank, that the Square Group is well managed and efficient. But even the best
set of financial statements may need other information when dealing with the needs of a
user such as the bank or the taxation authorities.
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Knowledge Check Question
Question 5
Though the SME-FRF and SME-FRS generally follow an historical cost basis of accounting,
this does not mean there is a complete absence of fair values. List two examples of when
fair values might be used in applying the SME-FRF and SME-FRS.
2 . 3 HKFRS FOR PRIVATE ENTITIES (PE):
CONCEPTS AND PRINCIPLES
The Hong Kong Institute of Certified Public Accountants (HKICPA) issued the Hong Kong
Financial Reporting Standard for Private Entities (HKFRS-PE) as a financial reporting option
for private entities on 30 April 2010 with the objective to ease the reporting burden of private
entities by relieving them of the requirement to apply the full HKFRS. As indicated previously,
it embodies the requirements of the IASB’s IFRS for SMEs, which has been adopted by many
countries around the world.
As for Section 2.2, the learning objectives for this section do not require a detailed
knowledge of individual requirements set down in the HKFRS-PE but are aimed at an
appreciation of the nature of the requirements and when they can be applied.
Unlike for the SME-FRF and SME-FRS, the concepts principles of the HKFR-PE are included as
HKFRS-PE sections in the same document as the individual topic sections. Including concepts and
Section 2 principles, there are 35 sections. Section numbers are provided as each topic is covered.
2.3.1 HKFRS Topics Not Covered by HKFRS-PE
To benchmark the HKFRS-PE, compare its coverage to that of the HKFRS, highlighting what it
does not cover that is covered by the HKFRS.
As for the SME-FRF and SME FRS, the concentration in this section is on those features of
the HKFRS-PE that are more relevant to choosing which standard to apply.
In Section 2.5, we compare all three sets of financial reporting requirements in Hong Kong
in a more detail.
The list of HKFRS topics not covered by HKFRS-PE is much shorter than for SME-FRS.
They are:
• HKFRS 5 Non-current Assets held for Sale and Discontinued Operations
• HKFRS 8 Operating Segments
• HKFRS 12 Disclosure of Interests in Other Entities
• HKFRS 13 Fair Value Measurement
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• HKFRS 14 Regulatory Deferral Accounts@
• HKFRS 15 Revenue from Contracts with Customers*
• HKFRS 16 Leases*
• HKFRS 17 Insurance Contracts
• HKAS 26 Accounting and Reporting by Retirement Benefit Plans@
• HKAS 33 Earnings per Share
• HKAS 34 Interim Financial Reporting
@ These standards are not within scope of Module 11.
* Instead of HKFRS 15 and 16 in the preceding list, past HKAS standards (HKAS 18 Revenue and
HKAS 17 Leases) are used.
HKAS 18
and HKAS As in the SME-FRS, in the cases of HKFRS 15 and 16, the requirements of the HKFRS-PE for
17 revenue and leases come from past HKFRS (i.e., HKAS 18 Revenue and HKAS 17 Leases).
Some section names differ slightly from those used in the HKFRS, but the HKFRS-PE
sections do address the topics covered by the HKFRS.
The first point to observe about the preceding list of omitted standards is that some cover
topics that are irrelevant for Hong Kong private companies (e.g. HKAS 26, HKAS 33, HKAS 34
and HKFRS 8, HKFRS 14 and HKFRS 5). The second is that although the HKFRS-PE covers
financial instruments in Section 11 (Basic Financial Instruments) and Section 12 (Other Financial
Instruments), it does so differently from HKFRS (in HKFRS 7 and 9 and HKAS 32). The third
observation is that, as for the SME-FRS, where conventional accounting has some history in
practice, it has not been upset by the introduction of new standards (HKFRS 15 and HKFRS 16
as previously mentioned).
However, it should be recognised that the IFRS for SMEs, and its Hong Kong version,
HKFRS-PE, are derived, respectively, from the IFRS and IFRS for SMEs. This means that the
differences between the IFRS and HKFRS-PE are to be found in individual sections seemingly
covering the same topics as addressed in IFRS and HKFRS standards.
In Section 2.4, the differences between HKFRS and HKFRS-PE are provided in overview. As in
the case of the SME-FRS, the coverage is no substitute for reading both sets of requirements.
As indicated, in Section 2.5, there is a comparative analysis, with more detail, of the three
Hong Kong sets of financial reporting requirements.
2.3.2 Private Entities: Criteria and Eligibility
The HKFRS-PE is aimed at private entities and is equivalent to the IFRS for SMEs issued by the
IASB. The HKICPA has chosen to reserve the acronym SME for the subset of private companies
eligible for the CO exemption. See Section 2.2 for the requirements if the company will use the
exemption. Those requirements are less onerous than for the HKFRS-PE.
A private entity is one that does not have public accountability but that does issue general
purpose financial statements to external users.
Public accountability is required if an entity has instruments (debt or equity) that are
publicly traded (or are in the process of becoming so). It is also required if the entity holds
assets in a fiduciary capacity for a broad group of parties (e.g. as a bank, credit union, insurance
company, security broker/dealer, mutual fund or as an investment bank).
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If public accountability is required, an entity must apply the full HKIFRS. The HKFRS-PE
contains no size limitation and shareholders’ approval is not required for its adoption.
The company can adopt it within a group even if the parent uses the HKFRS or IFRS for its
consolidated financial statements.
Illustrative Example 4
Square, as described in the opening case, does not have public accountability and
prepares financial statements only for the use of the Inland Revenue Department (for
tax filing purposes) and for its bank’s purposes (to meet loan agreement and borrowing
criteria). Square Limited would be entitled to apply the HKFRS-PE. Square might also be
entitled to apply the SME-FRF and SME-FRS (as discussed in Section 2.2), which would
afford Square further accounting simplifications and compliance cost reductions. To do
so, however, the further eligibility criteria previously described would need to be met.
Illustrative Example 5
Assume that Square is a public company and Rectangle and Triangle, its subsidiaries,
wish to apply HKFRS-PE. Can those subsidiaries do so? How will external users know
what they have done? Yes, they can, and the form of their directors’ report and auditor’s
report will identify the framework with which they are complying.
2.3.3 Benefits from Adopting the PE Financial Reporting Framework
Similar to the SME-FRF, the HKFRS for PE simplifies the full HKFRS and is, therefore, easier
to follow. Further, the HKFRS-PE is not subject to change as frequently as the HKFRS. The
reporting costs and workloads of private entities can be reduced significantly, depending on the
complexity of their situations.
2.3.4 Objective and Qualitative Characteristics
The objectives of the HKFRS-PE, and the qualitative characteristics that make their information
useful, are expressed in terms similar to the HKFRS. Information is intended to be useful for
HKFRS-PE economic decision making, and information needs to be relevant to be representationally
2.2–2.12 faithful, understandable and comparable.
The difference is that standard-setters, in weighing costs and benefits, face a
different situation when dealing with private entities whose financial statements are not
lodged in a public record. There are fewer dependent users, some can gain access to
additional information if required and the transactions of such entities are generally more
straightforward.
The HKFRS-PE and SME-FRS contain simplifications to allow for the differences in their cost/
benefit equations when compared with publicly accountable entities following HKFRS.
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Illustrative Example 6
Trapezoid Limited (Trapezoid) is a private company, currently adopting the HKFRS for PE
in preparing its financial statements. When considering the subsequent measurement of
its investment property under Section 16 of HKFRS-PE, which requires it to be measured
at fair value, it is confirmed that no active market exists for the investment property
due to its remote location. To measure the fair value of this investment property, the
company would need to incur extra cost. Trapezoid does not need the property to be
used to secure funding and the property is intended to be held for the long term with
the hope being that planning regulations will change and favour it. Any fair value in
the meantime is unlikely to be of more benefit to the management and shareholders
HKFRS-PE
than their knowledge of its cost. Therefore, Trapezoid may select the cost model under
16.7 HKAS 40 Investment Property to measure its investment property.
2.3.5 Elements
The definitions of the elements (assets, liabilities, revenues, expenses and equity) in the HKFRS
HKFRS-PE and HKFRS-PE are largely compatible and any differences will not have practical consequences
2.17–2.26 for private entities.
2.3.6 Recognition and Measurement
HKFRS-PE The recognition criteria for when to bring the elements to account (to recognise them) are set
2.27–2.32 out in each section of the standard. They are the same as for the HKIFRS’ Framework before the
2018 update. But as with the definitions of the elements, the changes are unlikely to affect
accounting by private entities.
The measurement principles of the HKFRS-PE relating to historical cost and fair value are
HKFRS-PE described in the same way as for the HKFRS, but individual standards invoke those principles
2.33–2.35 differently as described later in this chapter.
Knowledge Check Question
Question 6
If a private company is unable to gain the exemption under the CO that would enable it to
use the SME-FRF and SME-FRS, describe two of the key considerations you would draw to
the attention of an entity you are advising, when that entity is choosing between applying
the full HKFRS and the HKRS-PE.
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2 . 4 HKFRS FOR PE: ACCOUNTING,
PRESENTATION AND DISCLOSURE
This section indicates the more important differences between the requirements of the HKFRS
and HKFRS-PE. These differences are likely to be the most influential to a preparer choosing
between the two. However, once an entity chooses, it needs to apply the chosen will need to
be fully applied. This means that finer differences than noted here will need to be investigated.
Such differences are documented in the literature.
2.4.1 PE Simplifications of HKFRS Accounting
2.4.1.1 Financial Instruments
Under the HKFRS-PE, financial instruments are classified between simple (basic) financial
instruments (e.g. trade receivable and payables) and more complex instruments. Most of the
HKFRS-PE
Sections former are measured at amortised cost. The latter are generally measured at fair value through
11 and12 profit or loss. HKFRS requires that:
• Multiple measurement categories and those changes in fair value that are measured
will be taken to other comprehensive income or to the profit or loss, depending on
what is being measured and circumstances that arise;
• Financial assets are to be classified as measured at historical cost, fair valued through
other comprehensive income (OCI), or fair valued through profit or loss, depending on
the entity’s business model and the contractual characteristics of the cash flows of the
assets; and
• Financial liabilities are to be measured at amortised cost except for certain categories
(e.g. derivative liabilities are carried at fair value through profit or loss).
The HKFRS-PE classifications are easier to apply, and the amortised cost model will often
be consistent with the nature of the instruments that private companies have traditionally held
and for which they have accounted for using that model.
Further, the relative non-use of OCI in the HKFRS-PE makes it less susceptible to the
changes coming through the full HKFRS and to the debates over aspects of classifications that
are often seen in the accounting of public companies.
2.4.1.2 Business Combinations
Under the HKFRS-PE, transactions costs are capitalised into acquisition costs; under the HKFRS,
they are taken to profit or loss. Contingent consideration would only be included in acquisition
cost if it was probable (more likely than not, greater than 50%), and the fair value could be
measured reliably. Under the full HKFRS, such consideration would need to be measured at fair
value, if material, considering the probability level applicable (e.g. 30%, 40%).
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2.4.1.3 Investments in Associates and Jointly Controlled Entities
HKFRS-PE
Sections The cost model, the equity method of accounting model and fair value model are permitted
14 and 15 under the HKFRS-PE; under the full HKFRS, the equity method must be used.
2.4.1.4 Research and Development (R&D) Costs
HKFRS-PE
Section Under the HKFRS-PE, all research and development (R&D) costs must be expensed when
18 incurred. Under the HKFRS, research costs are to be expensed as incurred, but development
costs must be capitalised and amortised if certain criteria are met.
2.4.1.5 Income Taxes
Under the HKFRS, a deferred tax asset will be recognised if it can probably be recovered against
future taxable income.
Under the HKFRS-PE, the deferred tax asset will be brought to account gross, with a
valuation adjustment being applied so the net carrying amount equals the highest amount that
is more likely than not to be recovered.
Despite this difference of approach, the net balances under both are likely to be the same.
2.4.1.6 Investment Property
HKFRS-PE
Section Under the HKFRS-PE, the fair value model may be used if it is practicable to do so without
16 undue cost or effort. Otherwise, cost model is applied. Under the HKFRS, a choice must be
made between the cost model and the fair value model, and that choice must be applied to all
investment properties held.
HKFRS-PE 2.4.1.7 Property, Plant and Equipment
Section
17 Under the HKFRS-PE, these will be measured at cost/amortised cost. Under the HKFRS, a choice
can be made between the cost model and a fair value model. Once chosen, the model should
be applied consistently at a class of assets level.
2.4.1.8 Intangible Assets (Including Goodwill)
Under the HKFRS-PE, these assets are assumed to have finite lives and are accounted for
HKFRS-PE
Sections initially at cost and then amortised. They are not tested for impairment unless something
18 and 19 indicates otherwise. Under the HKFRS, intangible assets other than goodwill could, if certain
criteria are met, be accounted for under a revaluation model. Only assets with a finite life are
amortised, and goodwill is only decreased in amount when impaired. Impairment must be
tested for annually.
2.4.1.9 Borrowing Costs
HKFRS-PE
Section Under the HKFRS-PE, these costs are recognised as an expense in profit or loss in the period in
25 which they are incurred. No capitalisation is allowed.
Under the HKFRS, borrowing costs are to be capitalised when directly attributable to
qualifying assets, meaning assets that need to be made ready for use (constructed) over an
extended period.
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2.4.1.10 Exchange Differences
Under the HKFRS-PE, exchange differences relating to a net investment in a foreign operation
HKFRS-PE and recognised initially in OCI are not reclassified in profit or loss on disposal of the investment
BC123 in a foreign subsidiary. Under the HKFRS, such differences are reclassified from equity
to profit and loss.
2.4.2 PE Simplified Presentation
Based on the needs of users of private entities’ financial statements and costs to smaller
entities, the HKFRS-PE reflects the following simplifications of presenting the financial
statement:
• 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. This option does not exist in the full HKFRSs;
• If an entity has no items of OCI in any of the periods for which financial statements are
presented, it can present only an income statement; and
HKFRS-PE
Sections • All deferred tax assets and liabilities should be classified as non-current assets or
3–8 liabilities.
2.4.3 PE Simplified Disclosure
The disclosure requirements in the HKFRS-PE are substantially reduced when compared with
the disclosure requirements in the full HKFRSs. The reasons for the reductions are of four
principal types:
1. Some disclosures are not included because they relate to topics covered in HKFRSs that
are omitted from the HKFRS-PE;
2. Some disclosures are not included because they relate to recognition and
measurement principles in the full HKFRSs that have been replaced by simplifications in
the HKFRS-PE;
3. Some disclosures are not included because they relate to options in the full HKFRSs that
are excluded in the HKFRS-PE. For example, there is no requirement to disclose the fair
value of investment property that is measured using the cost model; and
4. Some disclosures are excluded based on the judgement of standard-setters about the
balance between users’ needs/benefits and costs.
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Knowledge Check Questions
Question 7
Explain at least four simplifications specified in the HKFRS-PE as compared with the
full HKFRS
Question 8
Explain why three topics have been omitted from HKFRS-PE as compared with the
full HKFRS.
2 . 5 COMPARISON OF THE THREE HONG KONG
FINANCIAL REPORTING FRAMEWORKS:
FULL HKFRS, HKFRS-PE AND SME-FRF
AND SME-FRS
Exhibit 2.2 provides a topic-by-topic summary of the differences among the three frameworks.
Full HKFRS HKFRS for PE SME-FRF and SME-FRS
Scope and application
Qualifying Criteria: Criteria: Criteria:
entities Applicable to all publicly See Section 2.3. See Exhibit 2.1.
accountable entities in Can be applied by private Companies may need to
preparing their required companies that are not meet certain shareholder
general purpose financial publicly accountable but agreement requirements,
statements. Applies to prepare general purpose size test or both.
the general purpose financial statements for Qualifying companies
financial statements external users. are not to be publicly
of all profit-oriented Owners’ consent is not accountable.
entities, including those required to elect to adopt Some companies could
engaged in commercial, the HKFRS-PE. qualify for the HKFRS-PE
industrial, financial and
There are no size criteria to and SME-FRF and SME-FRS
similar activities whether
be met. and, if so, choose which
organised in corporate or
Certain types of businesses set of requirements they
in other forms.
are precluded because of apply.
Could be adopted by other
the accountability of their The same preclusions
entities.
role (e.g. in banking, deposit of certain types of
taking, as a regulated businesses for the
business or in insurance). HKFRS-PE apply.
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Full HKFRS HKFRS for PE SME-FRF and SME-FRS
Concepts and Pervasive Principles
Accrual basis? Yes Yes Yes
Measurement
bases Measurement bases Initial recognition: historical Mostly historical cost
include cost-based cost except certain situations,
(historical cost, amortised Subsequent measurement for example:
cost); and is mostly at historical cost or Foreign currency
Value-based (fair value, net amortised cost. monetary items (closing
realisable value, value in Fair value (available for rate of reporting date);
use). These depend on the investments in associates Finance lease (present
nature of the item being and joint ventures, value of the minimum
measured and selection of investment property, lease payments); and
a measurement basis can agricultural assets). Impairment of assets
lead to changes in values
(carrying amount less
being taken to the profit
recoverable amount).
or loss or to OCI. In some
cases, the measurement
basis is stipulated (e.g. Assets should not be
fair value for certain revalued nor should
derivatives); in other cases, future cash flows be
an option is provided (e.g. discounted in the
revaluation of property measurement of assets
plant and equipment). and liabilities except when
required or permitted.
Presentation of financial statement
Results of HKAS 1 requires financial The application of Result in financial
application of statements to present HKFRS-PE, with additional statements that comply
the standard fairly the entity’s financial disclosure when necessary, with the SME-FRF and
performance, financial is presumed to result in SME-FRS.
position and cash flows financial statements that
in accordance with the achieve a true and fair view
HKFRS. of the financial position,
financial performance and
cash flows of private entities
in accordance with the
HKFRS-PE.
Complete set A statement of financial As for the HKFRS, a cash flow Cash flow statement is
of financial position; statement and a statement optional.
statements A statement of profit or of changes in equity are Changes in equity can
loss and OCI; required. However, under either be disclosed in
limited circumstances, it may the notes to the financial
A statement of changes in
be combined with statement statements or disclosed
equity;
of comprehensive income as a separate component
A statement of cash flows; by presenting a statement of the financial
Notes to the accounts; and of income and retained statements.
Comparative information earnings.
in respect of the preceding
period.
Statement of Option to choose indirect Same as the full HKFRS. Same as the full HKFRS.
cash flows or direct method for
presenting cash flows from
operating activities.
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Full HKFRS HKFRS for PE SME-FRF and SME-FRS
Additional An entity should provide The same for HKFRS. No specific requirement
disclosure additional disclosures on the disclosure of
when compliance with information about
the specific requirements judgements about the
in the HKFRSs is future and key sources of
insufficient to enable estimation uncertainty.
users to understand
the impact of particular
transactions, other
events and conditions
on the entity’s financial
position and financial
performance. Information
is also required about
the assumptions it makes
about the future and
estimation uncertainty
that affect the application
of the entity’s accounting
policies and involve a
significant risk of causing a
material adjustment to the
carrying amount of assets
and liabilities within the
next financial year.
Full HKFRS HKFRS for PE SME-FRF and SME-FRS
Presentation of financial statement
Application A parent entity shall The same for the HKFRS Consolidated financial
to group present consolidated except that a parent need not statements will be required of a
accounts financial statements present consolidated financial parent entity unless it meets the
that include all its statements if: following exceptions:
subsidiaries. • The parent is itself a (a) It is a wholly owned
A parent need not subsidiary and the subsidiary of another
present consolidated ultimate parent (or any entity at the end of the
financial statements intermediate parent) financial year; or
if: produces consolidated
(b) It is a partially owned
• The parent is general purpose financial
subsidiary of another
itself a subsidiary statements that comply
entity at the end of the
and the ultimate with the full HKFRSs, IFRS,
financial year and it meets
parent (or any HKFRS-PE or IFRS for
either of the following
intermediate SMEs.
conditions:
parent) If a company has no
produces subsidiaries other than one (i) At least six months
consolidated acquired with the intention of before the end of the
general purpose selling or distributing it within financial year, the
financial one year, it is not required to directors notify the
statements that prepare consolidated financial members in writing
comply with the statements. of the directors’
full HKFRSs. intention not to prepare
consolidated financial
statements for the
financial year, and the
notification does not
relate to any other
financial year;
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Full HKFRS HKFRS for PE SME-FRF and SME-FRS
Application Investment (i) As of a date falling three
to group entities are not to months before the end
accounts consolidate their of the financial year, no
subsidiaries but member has responded
must measure their to the notification by
investments in those giving the directors
entities at fair value a written request for
through profit or the preparation of
loss. consolidated financial
statements for the
financial year;
(ii) All members agree
in writing before the
end of the financial
year that consolidated
financial statements
will not be prepared for
the financial year, and
the agreement does
not relate to any other
financial year 9;
or,
(iii) All its subsidiaries
qualify for exclusion
from consolidation
based on immateriality
or consolidation
would involve undue
cost or delay.
Retrospective If it is impossible to The same for HKFRS. The same for the HKFRS
application determine exactly although the wording differs.
when the initial Comparative information
transaction was presented for a prior period
recorded in the need not be restated if restating
financial statements, the information would require
that is, impracticable undue cost or effort.
to determine, then
the adjustment
will be made in
the comparative
information in the
current financial
statements.
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Full HKFRS HKFRS for PE SME-FRF and SME-FRS
Financial instruments
Scope Applies to Financial instruments are The only coverage of financial
all financial classified as basic or as falling instruments relates to
instruments, under requirements for ‘other investments in securities
including a financial financial instruments’ (i.e. are (generally covered in Section 6
instrument, which more complex). of the SME-FRS, Investments) and
is part of a hedging Entities can elect to apply forward contracts addressed
relationship that HKAS 39. in Section 15 of SME-FRS, The
qualifies for hedge Effects of Changes in Foreign
accounting. The Exchange Rates.
requirements Basic financial instruments
are extensive These comprise cash, simple
and potentially debt instruments (such as
complex for some loans payable or receivable),
instruments. a commitment to receive a
loan and an investment in
non-convertible preference
shares and non-puttable
ordinary and preference
shares.
A debt instrument qualifies
as basic if it satisfies the
following conditions:
• It provides unleveraged
returns to holders that
are easily determined;
• No contractual provision
exists that could, by its
term, result in the holder
losing the principal
amount or interest
attributable to the current
or prior periods;
• Any contractual terms
that permit early
repayment are not
contingent on future
events; and
• No conditional returns
or repayment provisions
exist other than those
previously listed.
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Full HKFRS HKFRS for PE SME-FRF and SME-FRS
Initial and At initial recognition, On initial recognition, a Not covered.
subsequent an entity shall basic financial instrument
measurement measure a is measured at transaction
financial asset or price unless the arrangement
financial liability at is a financing transaction.
approximately its In this case, it is the present
fair value, in the value of the future payment
case of a financial discounted using a market
asset or financial rate.
liability not at fair At the end of each reporting
value through profit period basic financial
or loss, transaction instruments are measured as
costs that are follows:
directly attributable
• Debt instruments are
to the acquisition or
measured at amortised
issue of the financial
cost;
asset or financial
liability. • Commitments to receive a
loan are measured at cost
A financial asset
(which could be nil) less
shall be measured
impairment if applicable;
at amortised cost
and
if it satisfies the
business model • Investments in
and cash flow non-convertible or
characteristics test. non-puttable shares are
Other financial measured at fair value if
assets are measured the shares are publicly
at fair value. traded or fair value can
be measured reliably.
Otherwise they are
measured at cost less
impairment.
More complex financial
instruments
These are measured at fair
value on initial recognition and
at each reporting date except
for situations where there is
no longer a reliable measure
of fair value. In this case, an
entity continues to carry that
instrument at its last available
fair value, which is treated as
cost, subject to impairment,
until the instrument is
de-recognised or its fair value
becomes available.
Changes in the fair value of
basic financial instruments are
taken to profit or loss. (See the
following hedge accounting.)
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Full HKFRS HKFRS for PE SME-FRF and SME-FRS
Hedging Hedge accounting is Hedge accounting is permitted Hedging requirements are
optional. for four types of transactions: limited to forward contracts
When adopted, 1. Interest rate risk of a debt addressed in Section 15 of the
it provides the instrument measured at SME-FRS, The Effects of Changes
accounting for three amortised cost; in Foreign Exchange Rates.
types of hedges: 2. Foreign exchange or
1. Fair value interest rate risk in a
hedges; firm commitment or a
2. Cash flow highly probable forecast
hedges; and transaction;
3. Hedges of a net 3. Price risk of a commodity
investment in a or in a firm commitment
foreign entity. or highly probable
forecast transaction
to purchase or sell a
commodity; or
4. Foreign exchange risk
in a net investment in a
foreign operation.
(These hedging transactions
are also addressed in the
HKFRS.)
Property, Plant and Equipment
Measurement Initial recognition Cost/depreciated cost, less The same for HKFRS-PE.
at and at cost. Subsequent accumulated impairment If transitioning from another
after initial measurements losses. GAAP, the previous GAAP
measurement at depreciated carrying amount, or fair value,
cost or using the on transition may be elected as
revaluation model. deemed cost.
Full HKFRS HKFRS for PE HK SME-FRF and
SME-FRS
Investments in associates and joint ventures
Measurement Only equity method is allowed. Optional to choose a No separate section
at and Cost model, on investment in
after initial associates and joint
Equity method, or
recognition ventures.
Fair value model.
Such investments are
carried at:
• The lower of cost
and net realisable
value for current
investments; and
• Cost less
accumulated
impairment losses
for long-term
investments or,
in consolidated
financial statements,
the equity method
may be applied for
associates.
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Full HKFRS HKFRS for PE HK SME-FRF and
SME-FRS
Investment property
Measurement Entity may choose the fair value Investment property Covered in Section 3
after initial model or cost model. whose fair value can Property, Plant and
recognition Under the fair value model, be measured reliably Equipment. There is no
changes in fair value are taken without undue cost separate section on
to profit or loss. or effort shall be investment property.
measured at fair value The definition of PPE
Under the cost model, HKAS
at each reporting date includes property held
16 applies, and the property is
with changes in fair for rental and/or for
carried at cost/amortised cost,
value recognised in investment potential.
less accumulated impairment
profit or loss.
losses. Investment property
An entity shall account should be carried
for all other investment at its cost less
property as PPE, using any accumulated
the cost/amortised depreciation and
cost, less accumulated accumulated
impairment losses. impairment losses.
Intangible assets other than goodwill
Recognition An ‘identifiable’ intangible asset Intangible assets are The same for
of intangible is to be recognised when the to be recognised at the HKFRS-PE.
assets normal recognition criteria for cost/amortised cost, If transitioning from
(including asset recognition are met. After less accumulated another GAAP, the
those initial recognition the entity impairment losses. previous GAAP carrying
developed can choose to apply the cost An entity shall amount, or fair value,
internally) model or the revaluation model recognise expenditure on transition may be
(subject to certain conditions). incurred internally elected as deemed
For internally generated on an intangible cost. An intangible
intangibles, though research item, including all asset arising from
costs must be expensed when expenditure for R&D development should
incurred, development costs are activities, as an expense be recognised only if
to be capitalised if an entity can when it is incurred certain specified criteria
demonstrate all of the following: unless it forms part are met.
• The technical feasibility of of the cost of another
completing the intangible asset that meets the
asset; recognition criteria in
the HKFRS-PE.
• The availability of adequate
technical, financial and
other resources to complete
the development;
• The entity’s intention to
complete the intangible
asset;
• The entity’s ability to use or
sell the intangible asset;
• The asset probably
generates future economic
benefits; and
• The expenditure
attributable to the
intangible asset can be
reliably measured during
development.
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Full HKFRS HKFRS for PE HK SME-FRF and
SME-FRS
Useful life and Intangible assets can be All intangible assets The same for HKFRS-PE.
amortisation classified as being of indefinite shall be considered to
period life or finite life. An intangible have a finite useful life.
asset with an indefinite useful If an entity cannot make
life should not be amortised a reliable estimate of
but should be subject to annual the useful life of an
review for impairment. intangible asset, the life
shall be presumed to
be 10 years.
An entity shall allocate
the depreciable amount
of an intangible asset
on a systematic basis
over its useful life.
Full HKFRS HKFRS for PE HK SME-FRF and
SME-FRS
Business combinations and goodwill
Measurement Business combinations are Business The same for the
at and accounted for using the combinations are HKFRS-PE except that
after initial acquisition method with assets accounted for using (i) There is a
recognition acquired and liabilities assumed the acquisition rebuttable
being measured at fair values method, which is presumption that
(with limited exceptions). the same as the the useful life
full HKFRS except of goodwill will
Goodwill is measured as the that goodwill is not exceed five
difference between the fair values measured at cost years (with annual
of net identifiable assets acquired less accumulated reviews if the
and the fair value of consideration amortisation and presumption is
(full goodwill method) or is impairment losses. rebutted); and
measured proportionately If a reliable estimate (ii) There is a
allowing for any outside equity of the useful life of 12-month limit
interests (partial goodwill method). goodwill cannot be on revising
made, it is presumed contingent
Goodwill is subsequently to be 10 years. consideration
measured at cost less (absent an error).
accumulated impairment losses. Contingent
It cannot be revalued, and consideration is Bargain purchases: the
impairments cannot be reversed. included in cost if same for the HKFRS and
its incurrence is HKFRS-PE.
Goodwill is allocated to cash probable and can be
generating units for the purpose measured reliably Other costs attributable
of testing for impairment. at acquisition or to an acquisition are
subsequently. expensed as incurred.
Contingent consideration is
accounted for at fair value. Bargain purchases: the Goodwill impairment:
same for the HKFRS. the same for HKFRS-PE.
Bargain purchases, after
reassessment of the identifiable Other costs
assets and liabilities, are to be attributable to an
reflected in profit or loss. acquisition are
capitalised.
Other costs attributable to an
acquisition, such as accounting Goodwill impairment:
and legal fees, are expensed as the same for the
incurred. HKFRS.
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Full HKFRS HKFRS for PE HK SME-FRF and
SME-FRS
Leases
Lessees HKFRS 16 to apply. With limited Old HKAS 17 is The same for HKFRS-PE.
exceptions, all lease assets and followed in which
lease liabilities are brought to finance leases are
account (capitalised) under capitalised and
what is termed a property rights operating leases are
approach. Many more lessee expensed under an
leases will be ‘on-balance-sheet’ approach, which
under this approach than broadly sought to
traditionally. account for leases
that were quasi-
purchases as if the
leased asset was
purchased and a
financing liability
incurred. Few leases
have been capitalised
than will be under the
new standard.
Lessors The lessor records an asset Same as the full The same for HKFRS-PE.
leased under a finance lease HKFRS. The revisions
at an amount equal to the net to lessee accounting
investment in the lease. This is in the HKFRS were not
the gross investment in the lease, extended to lessor
discounted at the interest rate accounting, which
implicit in the lease. often sees leases
The lessor records operating accounted for as
lease assets according to receivable.
the nature of the assets and
depreciates them on a basis
consistent with the normal
depreciation policy for similar
owned assets. Rental income
is recognised on a straight-line
basis over the lease term unless
another systematic basis is more
representative of the time pattern
over which the benefit of the
leased asset is diminished.
Full HKFRS HKFRS for PE HK SME-FRF and
SME-FRS
Revenue
Contracts with Five-step model is Revenue is recognised The same for HKFRS-PE.
customers applied. Revenue is when the entity
recognised as and gains control over
when performance assets forming the
obligations to the consideration. This is
customer are met. This an asset inflow model,
is sometimes called a which was employed in
liability relief model. As HKAS 18 and HKAS 11
the liability is met, the on construction
revenue is recognised. contracts.
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Full HKFRS HKFRS for PE HK SME-FRF and
SME-FRS
Recognition of interest, Interest is recognised The same for the The same for the
royalties and dividends using effective interest HKFRS. HKFRS-PE except that
method. Royalties are interest income is said
accrued when owing to be measured on a
and dividends when time proportionate
a right to receive is method.
established
Government grants: Are to be recognised The same for the Grants are to be
recognition and when the entity HKFRS. recognised in income
measurement complies with related over the periods
conditions and the necessary to match
grants are reasonably them to the related
assured. costs they are intended
Grants to compensate to compensate.
costs are to be deferred
and taken to profit
or loss as costs are
incurred; performance
conditions are met.
If relating to past, costs
are to be taken to profit
or loss when accrued.
Grants relating to
assets are to be
accounted for as
deferred income or as
a deduction from the
carrying amount of the
asset.
Employee benefits Short-term employee The same for the There is no explicit
entitlements are HKFRS. coverage; so, general
accrued as employee accrual principles would
services are rendered apply.
(at undiscounted
amounts).
Profit-sharing and
bonus plans are
accounted for as
accruals when
the entity has a
present obligation or
constructive obligation,
and the obligation can
be reliably estimated.
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Full HKFRS HKFRS for PE HK SME-FRF and
SME-FRS
For post-employment
benefits under a
defined contribution
plan, the entity
must apply accrual
accounting at
undiscounted amounts
for short-term liabilities
and for long-term
amounts using a
discount reflective of
high-quality corporate
bonds.
For define benefit plans,
the actuarial projected
unit credit method
will be needed to
determine the present
value of the defined
benefit obligations,
related service cost
and, if applicable, past
service cost.
Borrowing costs
Recognition Borrowing costs All borrowing costs An entity can choose
in relation to are recognised as an between an accounting
the acquisition, expense in profit or loss policy of expensing
construction and in the period in which all borrowing costs or
production of a they are incurred. choose capitalising
qualifying asset should those that meet the
be capitalised as part of criteria of being directly
the cost of the relevant attributable to the
asset. acquisition, construction
or production of a
qualifying asset.
Income Tax
Accounting income The liability method of The same as the full Deferred tax assets
taxes deferred tax accounting HKFRS but disclosures and liabilities are not
is required. are reduced. recognised. A tax
A deferred tax asset payable model applies.
(liability) is recognised
when recovery or
settlement of the
carrying amount of
an asset or liability
would make future
tax payments smaller
(larger) than they would
be if the recovery or
settlement were to have
no tax consequences.
All deferred tax
assets and liabilities
should be classified as
non-current assets or
liabilities.
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Topics Not Addressed in Preceding Tables
HKFRS-PE and SME-FRS *Share-based payments
*Hyperinflation
*Industry-specific standards
1. Agriculture
2. Extractive Industries
3. Service Concessions
*Transitional provisions for adopting a different basis for reporting (e.g.
moving to the SME-FRS).
*Narrow aspects of recognition and measurement of liabilities and equity
dealing with prepayments for equity to be issued and measuring non-cash
distributions to shareholders at fair value.
EXHIBIT 2.2 Topics covered in the three reporting frameworks
2 . 6 CURRENT DEVELOPMENTS
At the time of writing the IASB is balloting an exposure draft for the second ‘comprehensive
review’ of IFRS for SMEs. It is also considering the comments on an exposure draft titled
‘Subsidiaries without Public Accountability Disclosures’. It is too early to judge the outcome of
these IASB projects.
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SUMMARY
• The SME Financial Reporting Framework (SME-FRF), SME Financial Reporting Standard
(SME-FRS) and the HKFRS for Private Entities (HKFRS-PE) apply to qualifying small and
medium-sized enterprises and other private companies where there is generally no need
to report widely to investors in the same way as a publicly traded entity does and no need
to redress compliance cost burdens, which would be unduly borne if these entities were
required to comply with the full HKFRS. The selection of one or other of these sets of
requirements is subject to various criteria outlined in Sections 2.2 and 2.3.
• The SME-FRF and SME-FRS are recognised by the Companies Ordinance (CO) as an
appropriate financial reporting framework for qualifying entities and accepted for income tax
and banking purposes.
• The HKFRS-PE is a body of GAAP converged with the IFRS for SMEs as promulgated by the
IASB, based on the principles in the full IFRSs but which provides for simplifications in the
standards and in applicable disclosure requirements.
• The SME-FRF sets out the broad objectives and basis of accounting on which the SME-FRS is
established.
• For SMEs incorporated in Hong Kong, the most significant users are likely to be owners,
government (in the form of the Inland Revenue Department) and creditors (such as banks),
that may have the power to obtain information additional to that contained in the financial
statements.
• The SME-FRF sets out two underlying assumptions for financial reporting: accrual and
going concern.
• Under accrual accounting, the effects of all transactions and other events are recognised
in the accounting records when they occur, rather than when cash or its equivalent is
received or paid.
• Financial statements are normally prepared on the assumption that an entity is a going
concern and will continue to operate for at least the foreseeable future.
• The SME-FRF sets out four qualitative characteristics: Understandability, Relevance, Reliability,
Comparability.
• Under the historical cost convention, 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. Also under this convention, liabilities are recorded at the amount of
proceeds received in exchange for the obligation, or in some circumstances (e.g. income
taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability
in the normal course of business. Assets are not revalued nor are future cash flows be
discounted in the measurement of assets and liabilities except when required or permitted by
the SME-FRS.
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• There are four sets of size tests in the CO for an entity to qualify to apply the SME-FRF and
SME-FRS. Private companies which do not have subsidiaries and are not a subsidiary of
another company do need not meet any size test to qualify provided that they obtain 100%
agreement (or other threshold if specified in the articles) from their shareholders for the
financial year.
• To gain exemption as a larger ‘eligible’ private company or group, at least 75% of the members
of the company or the holding company of the group (as the case may be) must pass a
resolution at a general meeting that the company or the holding company is to fall within the
reporting exemption for the financial year, and all the members holding the remaining voting
rights in that company or the holding company must vote for the resolution.
• For the HKFRS-PE, private entities are those companies that do not have public accountability,
that is, do not have equity or debt listed and traded on a public market or are not in a
regulated industry, such as a bank, insurance company or securities broker/dealer.
• HKFRS-PE contains no size limitation and shareholders’ approval is not required.
• HKFRS-PE specifies qualitative characteristics: Understandability, Relevance, Materiality,
Reliability, Substance over form, Prudence, Completeness, Comparability and Timeliness.
• HKFRS-PE specifies the two common measurement bases for measuring assets, liabilities,
income and expenses: historical cost and fair value. However, the individual sections of the
standard are more closely aligned to historical cost than fair value.
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MIND MAP
SMALL AND MEDIUM-SIZED ENTITY HKFRS FOR PRIVATE ENTITIES
FINANCIAL REPORTING FRAMEWORK (PE) – CONCEPTS AND PRINCIPLES
(SME-FRF) AND FINANCIAL REPORTING
Similar framework to HKFRS but
STANDARD (SME-FRS)
re-weighted for circumstances of private
Applicable to companies qualifying for companies which are not publicly
reporting exemption under CO accountability
Entities will qualify under shareholder Applies to general purpose financial
agreement and/or upon meeting size tests statements
Simplest form of recognised reporting Director and auditor assertions: true and
Assertions by directors and auditors fair in accordance with PE framework
FINANCIAL REPORTING
limited to compliance of the financial FRAMEWORK AND Simpler than HKFRS but more extensive
statements with this set of requirements STANDARD FOR SMALL than SME-FRS
SME–FRS AND MEDIUM-SIZED HKFRS-PE - ACCOUNTING, PRESENTATION
ENTITIES, AND AND DISCLOSURE
Comprises requirements for a qualifying FINANCIAL REPORTING
entity’s financial reporting STANDARD FOR Equates with IFRS for SMEs
Intention of approach, PRIVATE ENTITIES Open to any private company producing
• Standardising requirements IN HONG KONG general purpose financial statements
• Reducing complexity further than Intention of approach,
HKFR-PE • Standardising requirements
Largely historical cost based and often • Reducing complexity further than HKFRS
following conventional accounting Often historical cost based and mainly
following conventional accounting
FULL HKFRS
Designed for publicly accountable entities
Equates to IFRS
Answers to Knowledge Check Questions
Question 1
Answer A is incorrect. The standard is legislated in the Companies Ordinance (CO) and not
issued by the Hong Kong Legislative Council.
Answer B is correct. The SME-FRF and SME-FRS itself is promulgated by the Hong Kong
Institute of Certified Public Accountants (HKICPA).
Answer C is incorrect. The standard is administered by the Companies Registry and not
issued by them.
Answer D is incorrect. The standard is recognised as an acceptable basis of accounting by
the Inland Revenue Department and not issued by them.
Question 2
Answer A is incorrect. Qualifying entities applying the SME-FRF and SME-FRS do so to
minimise the cost of preparing financial statements.
Answer B is incorrect. Qualifying entities applying the SME-FRF and SME-FRS do so to
satisfy the reporting needs for income tax.
Answers C and D are correct. Though reporting to investors or potential investors and to
lenders and potential lenders may be served by financial statements prepared under the
SME-FRF, those statements have limitations when compared to full HKFRS.
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Question 3
The company is one that could choose to apply the SME-FRS and SME-FRS provided it does
achieve the 100% shareholder agreement for each period. There are no size tests for such
a company.
If the company cannot achieve the 100% shareholder agreement but is confident it could
achieve at least 75% agreement (with no dissenting shareholders), it will be wise to check
whether the company has the correct size tests in mind. The tests may incorrectly focus on
the tests for what they regard as an SME company.
If the company achieved support from 75% of its shareholders, the size tests would have
been that the entity did not exceed two of the following:
(a) Revenue of HK$200 million;
(b) Total assets of HK$200 million; or
(c) 100 employees.
The amounts in (a) and (b) are twice those for a small private company. The answer in (c) is
the same for larger and smaller private companies.
Question 4
The level of shareholder agreement is not required of a small private company. Rather, it
must not exceed two of the three size tests ($HK$100 million in revenue, $HK$100 million
in assets and 100 employees) for such a company.
(a) Only exceeds the revenue limit and, so, qualifies;
(b) Only exceeds the asset test, and so qualifies;
(c) Fails the asset and employee tests, and so does not qualify (and would not qualify
as a larger entity because its shareholder approval is below 75%); and
(d) Fails the revenue and assets tests, and so does not qualify (and would not qualify
as a larger company because its shareholder approval is below 75%).
Question 5
Any two of the following would be a correct answer:
• Financial instruments often need to be measured at fair value;
• Investments in associates and jointly controlled entities can be accounted for under
the cost model, equity model or fair value model; or
• Investment property can be carried at fair value (but may be accounted for at cost if
there is undue cost or effort in determining fair values).
Question 6
In choosing between applying the HKFRS and HKFRS-PE, assessing how to best serve
the needs of the entity’s external users is the most important issue. Under either set of
requirements, audited general purpose financial statements will be required. Users may
be more comforted by compliance with the broader requirements of the HKFRS as if the
entity was a publicly accountable entity. However, the needs of external users may not be
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as great as for such an entity (fewer users, relatively less exposure to lender requirements,
more straightforward transactions); therefore, the characteristics of the HKFRS-PE might
be more important in making a choice, that is, namely, that some of the requirements
are less costly and simpler to implement and the body of requirements is relatively stable
compared to the HKFRS (which can be expected to continue to evolve).
Question 7
HKFRS-PE applies:
• Simpler classification and measurement bases when accounting for financial
instruments (basic and other);
• The historical cost approach for property plant and equipment and for intangibles
and does not allow use of the revaluation models for these;
• An income tax payable model rather than a deferred tax model;
• An immediate write-off model for many intangibles, including those arising from
research and development, and for borrowing costs;
• Presumptions about the useful lives of intangibles and goodwill;
• A simplified set of disclosures; and
• Familiar older standards for accounting for revenue and leases.
Question 8
The list of HKFRS topics not covered by HKFRS-PE includes:
• HKFRS 5 Non-current Assets Held for Sale and Discontinued Operations (to simplify and
because less common for private entities);
• HKFRS 8 Operating Segments (only required of public companies);
• HKFRS 12 Disclosure of Interests in Other Entities (to simplify and because financial
interests between private companies is more straightforward);
• HKFRS 13 Fair Value Measurement (to simplify and because HKFRS-SE contains less
use of fair values);
• HKFRS 14 Regulatory Deferral Accounts (not relevant to many, if any, private
companies);
• HKFRS 15 Revenue from Contracts with Customers* (to simplify);
• HKFRS 16 Leases* (to simplify);
• HKFRS 17 Insurance Contracts;
• HKAS 26 Accounting and Reporting by Retirement Benefit Plans (out of scope);
• HKAS 33 Earnings per Share (only required of public companies); and
• HKAS 34 Interim Financial Reporting.
Additionally, segment information, earnings per share, and interim financial reporting that
are not relevant to private companies are not addressed.
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EXAM PRACTICE
QUESTION 1
(Adapted from Module A December 2016 Exam Paper)
Mr Lee owns a Hong Kong-incorporated company, Tiny Company Limited (‘TCL’), which
also directly owns a Hong Kong-incorporated subsidiary, Good Harvest Limited (‘GHL’).
Both companies are engaged in manufacturing knitted wear. Currently, TCL and GHL
prepare their financial statements in accordance with Hong Kong Financial Reporting
Standard (HKFRS). Both companies do not have public accountability and publish such
general purpose financial statements for external users. Mr Lee is considering whether
these companies can qualify for reporting under the Small and Medium-sized Entities
Financial Reporting Framework (SME-FRF) and can prepare the financial statements of
these companies for the year ended 31 December 20X2 in accordance with the Small
and Medium-sized Entities Financial Reporting Standard (SME-FRS). For the three years
ended 31 December 20X2, TCL and GHL reported the following information in their
management accounts:
TCL 20X0 20X1 20X2
HK$’000 HK$’000 HK$’000
Total revenue 8,492 6,127 5,681
Profit for the year 1,816 1,492 1,266
Total assets 16,001 18,572 13,048
Total liabilities 9,380 11,747 7,225
Employees in HK 3 3 3
GHL 20X0 20X1 20X2
HK$’000 HK$’000 HK$’000
Total revenue 165,830 189,905 167,102
Profit for the year 16,052 14,358 10,690
Total assets 222,785 225,429 201,163
Total liabilities 183,842 179,105 176,971
Employees in Mainland China 82 89 90
Employees in HK 14 13 12
Required:
(a) Explain whether the financial statements of TCL and GHL as well as the consolidated
financial statements of TCL can be prepared under the SME-FRS for the year ended
31 December 20X2.
(b) If TCL and GHL did not qualify for reporting under the SME-FRF, advise as to any other
suggestions for reporting to Mr Lee.
(c) ‘It is always good for every company to apply the SME-FRF compared with full HKFRS.’
Explain whether this statement is correct from the perspective of the preparers and
users of the financial statements, without going into details of accounting requirements.
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QUESTION 2
(a) Under the SME-FRF and SME FRS, describe the circumstances whereby a group would
not have to prepare consolidated financial statements.
(b) Describe when non-consolidation will cause a problem for those using the financial
statements of group entities and when those problems might not arise.
ANSWERS TO EXAM PRACTICE
QUESTION 1
1a. For the latest financial year, GHL and TCL can qualify for the reporting exemption if
they meet the relevant size tests in that financial year (i.e. the year ended 31 December
20X2) and/or in the immediately preceding financial year (i.e. the year ended
31 December 20X1) according to the Transition Provision in the SME-FRF and SME-FRS.
For the year ended 31 December 20X1, GHL failed to meet two out of three of the
size tests to qualify as a ‘larger eligible private company’, that is, total assets exceed
HK$200 million and the number of employees is over 100.
For the year ended 31 December 20X2, GHL failed to meet two out of three of the
size tests to qualify as a ‘larger eligible private company’, that is, total assets exceed
HK$200 million and the number of employees is over 100.
Because GHL is required to pass the size tests in 20X1 and/or in 20X2 before
becoming eligible for the first year, that is, 20X2. GHL is not qualified to prepare its
financial statements under SME-FRS for the year ended 31 December 20X2.
For the years ended 31 December 20X1 and 20X2, TCL met two out of three of
the size tests to qualify as a ‘small private company’, that is, total annual revenue and
total assets are less than HK$100 million and the number of employees is fewer than
100. No shareholder approval is required. Accordingly, TCL is qualified to prepare its
financial statements under the SME-FRS for the year ended 31 December 20X2.
However, because its subsidiary, GHL, failed to qualify as a ‘larger eligible private
company’, TCL cannot report its consolidated financial statements under the SME-FRS
for the year ended 31 December 20X2.
1b. As TCL and GHL do not have public accountability and publish general purpose financial
statements for external users, they are eligible and can opt to prepare their financial
statements under the HKFRS-PE.
1c. The statement is incorrect. Some companies may be reluctant to apply the SME-FRF
even if they are eligible. Reasons not to switch to the simplified regime might include
one or more of the following:
• Some companies are used to preparing the financial statements in accordance with
the full HKFRS. When they switch to applying the SME-FRF, this would constitute a
change in accounting framework, which shall be treated as a change in accounting
policy and would be applied retrospectively as required by the transition provision
in the SME-FRF and SME-FRS unless determining the cumulative effect of the change
is impracticable or it may result in undue costs to do so;
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• The financial statements are for external users (such as lenders, customers, or
other stakeholders), and readers commonly believe that the full HKFRS are more
widely accepted;
• For some companies, changing to the SME-FRF and SME-FRS may not materially
simplify the financial statements;
• If a company is part of a listed group that has to prepare the consolidated HKFRS
or IFRS financial statements; therefore, preparing the financial statements of the
company under the SME-FRS may require extra time and, hence, cost to track the
necessary consolidation adjustments; and
• In the future, if a company is likely to be part of an initial public offering (IPO) or of
interest to private equity investors, it would be considered necessary to apply the
full HKFRS in producing its financial statements.
QUESTION 2
(a) Consolidated financial statements will be required of a parent entity unless it meets the
following exceptions:
• It is a wholly owned subsidiary of another entity at the end of the financial year; or
• It is a partially owned subsidiary of another entity at the end of the financial year
and it meets either of the following conditions:
°° At least six months before the end of the financial year, the directors notify
the members in writing of the directors’ intention not to prepare consolidated
financial statements for the financial year, the notification does not relate to
any other financial year and, as of a date falling three months before the end
of the financial year, no member has responded to the notification by giving
the directors a written request for the preparation of consolidated financial
statements for the financial year;
°° All members agree in writing before the end of the financial year that
consolidated financial statements will not be prepared for the financial year and
the agreement does not relate to any other financial year 9; or
°° All its subsidiaries qualify for exclusion from consolidation based on
immateriality or because consolidation would involve undue cost or delay.
Thus, if the entity meets the above conditions, it could elect to not prepare
consolidated financial statements.
(b) Where a group has many inter-company transactions between numerous group
members, and does not prepare consolidated financial statements, users and
management will find judging the financial position and performance of the group
difficult. Consolidated financial statements eliminate the effects of such transactions
and show the affairs of the group as if it were a single economic entity.
For a simple group with few sets of financial statements and no inter-company
transactions, reviewing those sets individually (i.e. in unconsolidated form) may
be adequate.
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Part B
Concept of Ethics Where It Is
Appropriate to Adopt Ethical Stances
for Professional Accountants
in Business
Chapter 3 Code of Ethics for Professional Accountants
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3
Code of Ethics
for Professional
Accountants
CHAPTER TOPIC LIST
3.1 Introduction to Business Ethics 3.4 Safeguards
3.1.1 The International Ethics 3.4.1 Safeguards Created by the
Standards Board for Profession, Legislation or
Accountants (IESBA) Regulation
3.1.2 HKICPA Code of Ethics 3.4.2 Safeguards in the Work
3.2 Ethics Fundamental Principles Environment
3.2.1 Integrity 3.5 Professional Accountants
3.2.2 Objectivity in Business
3.2.3 Professional Competence 3.5.1 Conflicts of Interest
and Due Care 3.5.2 Preparation and Reporting of
3.2.4 Confidentiality Information
3.2.5 Professional Behaviour 3.5.3 Acting with Sufficient Expertise
3.5.4 Financial Interests,
3.3 Threats
Compensation and Incentives
3.3.1 Self-interest Threat
Linked to Financial Reporting
3.3.2 Self-review Threat
and Decision Making
3.3.3 Advocacy Threat
3.5.5 Inducements
3.3.4 Familiarity Threat
3.3.5 Intimidation Threat
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LEARNING OUTCOMES
PRINCIPAL LO6: DESCRIBE AND APPLY THE CONCEPT OF ETHICS WHERE IT IS APPROPRIATE TO
ADOPT ETHICAL STANCES FOR PROFESSIONAL ACCOUNTANTS IN BUSINESS
LO6.01: Explain and apply the Code of Ethics for Professional Accountants
6.01.01 Describe the fundamental principles and the conceptual framework
6.01.02 Classify and analyse threats to compliance with the fundamental principles
6.01.03 Analyse the effectiveness of available safeguards
6.01.04 Solve the conflicts in the application of fundamental principles for Professional Accountants
in business
6.01.05 Explain the requirements of the Code of Ethics for Professional Accountants
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C o d e o f E t h ic s f o r P r o f es s io na l Acco u n t a nt s
OPENING CASE
ABC HOLDINGS LIMITED
A BC Holdings Limited (ABC Holdings) is a big conglomerate in Hong Kong. The company is
involved in many businesses, like supermarkets and real estate.
In 2013, ABC Holdings was involved in a controversy related to the acquisition of the XYZ
Hotel that gained public attention and regulatory scrutiny. After ABC Holdings announced its
acquisition of XYZ Hotel, it was discovered that the CFO of ABC Holdings, Patrick Lee, CPA, had
undisclosed conflicts of interest in the deal as the officers were minority owners of the hotel
and the terms of the deal appeared to favour the officers of ABC Holdings. Being a CPA, Mr. Lee
was or should have been aware of the conflict of interest and disclosure requirements of
the HKICPA’s Code of Ethics for Professional Accountants. Mr. Lee had apparently put his
personal interests ahead of his responsibilities as CFO of ABC Holdings, as he stood to receive
a considerable personal gain from ABC Holding’s acquisition of XYZ Hotel and he failed to
disclose his interest in the company. After much criticism and three months of investigation
and discussion with the Securities and Futures Commission (SFC), the company called off
the deal.
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OVERVIEW
All professional organisations have adopted a code of conduct to guide their members in
performing their professional responsibility in the most ethical manner to gain public trust and
to preserve the reputation of their profession. All professional accountants are required to
perform their professional services ethically and objectively and to exercise due professional
care to sustain public trust and good reputation in the accounting profession. Ethics can
create a good reputation that takes years to build and can be destroyed instantly in this age of
increased transparency, regulations, public scrutiny and social media.
One important asset of the accounting profession is acting in the public interest.
Section 18A of the Hong Kong Professional Accountants Ordinance provides that the Hong
Kong Institute of Certified Public Accountants (HKICPA) council issue Statements of Ethics for its
member. The HKICPA’s Code of Ethics for Professional Accountants (COE or the Code) sets the
guidelines for practicing accountants and auditors in performing audit services in Hong Kong
and the mainland China.
This chapter:
• Defines ethics in general and business and professional ethics in particular;
• Discusses the requirements and application of codes of ethics for professional
accountants;
• Describes the ethics fundamental principles and the related conceptual framework;
• Illustrates the potential threats to compliance with fundamental principles;
• Presents the effectiveness of safeguards in addressing the threats; and
• Suggests ways to maintain the sustainability of the accounting profession worldwide.
3 . 1 INTRODUCTION TO BUSINESS ETHICS
Business ethics is a set of moral principles, best practices and standards that guide business
behaviour. Business ethics refers to the collective values of a business organisation that can
be used to evaluate whether the behaviour of the collective members of the organisation is
considered acceptable and appropriate and whether the business is held accountable for
its openness, integrity and behaviour. Business ethics focuses on upholding ethical values
in business, including values like honesty, integrity, trust, fairness and objectivity, whereas
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failing to apply these values leads to cases of unethical behaviour and sometimes even illegal
behaviour. Professional ethics consists of professional values, ethics, codes of conduct and
accountability that enable members to act in the best interest of the profession, the public and
the global society. Thus, the acceptance of ethical duties or responsibilities is the cornerstone
of a profession. Characteristics of a profession are:
• Existence of a common body of knowledge consisting of an intellectual skill obtained
through education, training, certification and continuing professional education;
• Adoption and adherence to a common code of conduct guiding professional behaviour
and action and holding members accountable for their actions; and
• Acceptance of a duty to society, the profession and its members.
The accounting profession worldwide is characterised by:
• Serving the public interest;
• Performing responsibly with integrity, competency, objectivity and transparency;
• Exercising due diligence in maintaining independence and improving the quality of
services provided;
• Protecting investors from receiving misleading audited financial reports; and
• Providing reasonable assurance that audited financial information and reviewed
non-financial information are relevant, useful and reliable.
Illustrative Example 1
Arthur Andersen, one of the big eight international public accounting firms, was the
watchdog of the accounting profession worldwide; the unethical conduct of several
partners caused the demise of the firm. In accounting, what we have is our reputation
and public trust in the accounting profession. When this reputation is damaged, we are
doomed to fail and vanish.
3.1.1 The International Ethics Standards Board for Accountants (IESBA)
The ethics conceptual framework (a structured ethical guidance for professionals to apply
the fundamental principles of ethics to various business situations) adopted by the American
Institute of Certified Public Accountants (AICPA) in 2014, encouraged the development of the
conceptual framework of the Code by the IESBA of the International Federation of Accountants
(IFAC) in 2016. Similar to the AICPA Code of Ethics, the IESBA code requires professional
accountants worldwide to intentionally increase their awareness of threats to their compliance
with the profession’s rules of ethical conduct and to establish safeguards to offset and/or
to eliminate those material threats. In compliance with the ethics conceptual framework,
professional accountants are required to examine every circumstance, questionable situation,
transaction or relationship by considering it through the eyes of a prudent, rational and
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reasonable third party. Thus, for each such circumstance, the practicing accountant must
consider whether and how this third party finds the member at risk of noncompliance with one
or more professional ethics rules. The practicing accountant must take steps to safeguard from
the potential rule violation by reducing this perceived risk. However, neither the AICPA nor the
IFAC has offered any suggestions for ethics-related risk assessment and management.
In promoting the Code, the HKICPA and the IFAC have developed their conceptual
framework. This conceptual framework requires members to increase their awareness of
significant threats to their compliance with its rules of conduct and to establish safeguards
to monitor and minimise those threats. In complying with ethics principles and applying the
conceptual framework, the practicing accountants should:
• Apply the conceptual framework;
• Analyse potential threats to compliance with the Code and its ethics fundamental
principles in particular;
• Consider whether threats to compliance are significant by evaluating identified
threats; and
• Implement the safeguards that would reduce identified threats to an acceptable level or
even eliminate those threats of noncompliance with the Code.
The IESBA Code of Ethics and HKICPA Code and related conceptual framework require
identification, assessment and management of threats and safeguards as explained in the
following subsections.
3.1.2 HKICPA Code of Ethics
In July 2020, the HKICPA revised its COE, which is based on the COE of the International Ethics
Standards Board for Accountants (IESBA), published by the IFAC in November 2018. The
discussion of COE in this chapter comes from the code of ethics for professional accountants
as promulgated by the HKICPA and the International Federation of Accountants (IFAC).
With a particular focus on the COE issued by the HKICPA in November 2018. To promote
internationalisation and convergence in accounting and auditing standards, the HKICPA has
adopted the International Code of Ethics for Professional Accountants issued by the IESBA
of the IFAC. Thus, the HKICPA requires its members to comply with the revised COE as of
July 2020. Underlying the revised 2020 COE are several principles. This chapter of Module
11 focuses on Parts 1 and 2 of the Code. Part 1 consists of three parts: complying with the
Code, the Fundamental Principles of Ethics and the Conceptual Framework for applying the
Code. Part 2 provides guidance on the application of the Code for professional accountants
in business. Exhibit 3.1 shows the overview of the requirements and application material for
professional accountants covered in the COE.
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Part 1
Complying with the code, fundamental principles and conceptual framework
(All professional accountants - Sections 100 to 199)
Part 2 Part 3
Professional accountants in business Professional accountants in public practice
(Sections 200 to 299) (Sections 300 to 399)
(Part 2 is also applicable to individual professional
accountants in public practice when performing
professional activities
Independence standards
(Parts 4A and 4B)
Part 4A – Independence for audit and review
engagements
(Sections 400 to 899)
Part 4B – Independence for assurance engagements
other than audit and review engagements
(Sections 900 to 999)
Glossary
(All professional accountants)
EXHIBIT 3.1 Requirements and application material for professional accountants
(Source: HKICPA Code of Ethics for Professional Accountants.)
3 . 2 ETHICS FUNDAMENTAL PRINCIPLES
Part 1 of the Code establishes the ethics fundamental principles and provides a conceptual
framework for ethics. The other parts present how the ethics conceptual framework applies
in certain situations and circumstances. The five ethics fundamental principles are integrity,
objectivity, professional competence and due care, confidentiality and professional behaviour.
The Code adopts a principles-based and a conceptual approach similar to the one by the
IESBA for ethics and independence. This section addresses five ethics fundamental principles.
These principles apply to all services performed by members whether they are employed in
public practice, the private arena, government or academia. Principles are the basic tenets
of ethical conduct and professional accountants should comply with the following five ethics
fundamental principles:
3.2.1 Integrity
Integrity is the most important element of the accountants’ code of conduct as rightfully stated
by Alan K. Simpson, Senator from Wyoming, ‘If you have integrity, nothing else matters. If you
don’t have integrity, nothing else matters’. Integrity is an element of character and fundamental
to professional recognition and demands that professional accountant be straightforward in
conducting their professional services.
Section 110.1(a) of the HKICPA’s COE describes integrity as being ‘straightforward and
honest in all professional and business relationships.’ Integrity also carries the implication of
fair dealing and is rooted in truth. Section 110 details that members must perform professional
responsibilities with the highest sense of integrity. As such, members must not knowingly be
a party to any reports, returns or any other form of information where the member believes
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there may be false or misleading statements and reckless statements or information, or has
information removed to be misleading. If a member becomes aware of any association to
aforementioned information steps should be taken to denounce that information and issue a
modified report where applicable.
The integrity of the financial reporting process can create the investor confidence in
financial information required for the efficient functioning of the capital markets. The integrity
of the process is a function of trustworthiness of all individuals involved including the board of
directors, particularly the audit committee, management, internal and external auditors, legal
counsel, investment banks and financial analysts. Specifically, the integrity and competence,
which is further discussed in Section 3.2.3 of this chapter, of those engaged directly in the
financial reporting process such as management, the audit committee and external auditors
greatly influence the quality and reliability of financial reports.
3.2.2 Objectivity
Objectivity means being impartial, unbiased and independent and does not allow undue
influence of others and potential conflicts of interest affect your independence and
professional or business judgement. Section 110.1 (b) of the HKICPA’s COE describes
objectivity as to not allow bias, conflict of interest or the undue influence of others to override
professional or business judgements. Additionally, Section 112 reminds that members will
be exposed to compromising situations that may make it difficult to remain objective. While
detailing those situations would be a tall order, a CPA should maintain objectivity and be free of
conflicts of interest in discharging professional responsibilities.
3.2.3 Professional Competence and Due Care
Sections 110.1(c) and 113 require that members consistently remain knowledgeable and
skillful enough to ensure employers get the most competent professional service supported
by technical, analytical and communication skills and ensure those services are based on
applicable regulations and professional standards. This level of care is expected from a prudent,
reasonable accountant. Additionally, members should exercise diligent, competent, thorough
and prompt care in performing professional services. Competence means that members
possess sufficient and appropriate technical skills to perform professional services. Diligence
means responsibly acting in accordance with the requirements of an assignment while being
careful, thorough and timely. This requires the understanding of professional standards, the
techniques, knowledge and the ability to exercise sound judgement in applying knowledge in
performing financial reporting activities. As such, members must make sure those working
under their authority are adequately trained or supervised and that employing organisations are
made aware of the inherent limitations of any services or activities performed.
3.2.4 Confidentiality
The general understanding is that the relationship between professional accountants and
their employing organisation is confidential, meaning the information acquired as a result of
professional and business relationships and/or evidence gathered by performing professional
services should not be disclosed to third parties without proper and specific authority and
permission from the employing organisation unless there is a legal or professional right or duty
to disclose, for example, demanded by court or other authorities. Such confidential information
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should not be used for the personal advantage of the professional accountant or third parties
as per Section 114 of the HKICPA’s COE.
As noted in Section 114.1 A1 of the HKICPA’s COE, confidentiality is imperative because it
enables the free flow of information from accountants’ employing organisation to accountants
that need the information by ensuring the employing organisation the information will not be
disclosed to a third party. Further, the Code requires accountants to maintain confidentiality of
employing organisation information even after the end of the relationship, per Section R114.2.
3.2.5 Professional Behaviour
The professional accountant must comply with all applicable laws, rules, regulations and
standards, and must avoid any conduct that discredits the accounting profession as per
Section 115.1 of the HKICPA’s COE. This means professional accountants should conduct their
professional service with the utmost professionalism.
Illustrative Example 2
From the opening case, ABC Holdings presents an example of a failure to meet the
fundamental principles of ethics. Mr. Lee, the CFO of ABC Holdings violated the following
three principles:
1. Integrity. Mr. Lee was not straightforward with his conflicts of interest in the deal
with the XYZ Hotel as he failed to disclose his minority ownership positions.
2. Objectivity. Mr. Lee had a clear conflict of interest in the case that could have
influenced his business judgement as he held a financial interest in both entities
involved in the deal.
3. Professional behaviour. The professional accountants involved in structuring,
documenting, and reporting the deal also did not perform their duties with
professional behaviour as the conflicts of interest should have been identified
and disclosed appropriately. These failures were responsible for the collapse
of the deal.
Apply and Analyse 1
A staff accountant working for a regional CPA firm has been on the team assigned to
maintain the financial records and financial reporting requirements for ABC Holdings for
the past two years. He has worked closely with members of the ABC Holdings management
and has developed strong relationships with them.
During the current period, he has been preparing receivable aging reports, which
are used for management reporting. He notices that only a small number, that is, fewer
than 5% of customer receivables are aged beyond 90 days. However, the balances in one
account named ‘Due from affiliated entity’ are routinely written off every three months.
He reviews the account details and determines that though receivables are applied to the
account each month, no payments have been made to this account and the total balance is
written off each quarter.
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Apply and Analyse 1 (continued)
After further analysis, the accountant reaches the conclusion that certain officers
of ABC Holdings were likely given ‘loans’ that were not repaid. He escalates his findings
to his manager who agrees with the conclusion. The issue is further escalated to senior
management of the CPA firm who informs ABC Holdings management, compliance and
internal audit. Feeling proud of his discovery and positive feedback he received from the
manager, he tells his friends and family about his finding.
Analysis
A clear lack of integrity is exhibited by the officers who received the ‘loans’ as well as the
accountants who executed the accounting. However, the accountant and the management
at the CPA firm demonstrated their objectivity by identifying and reporting their finding
without allowing the risk of damage to their relationship with ABC Holdings to influence
their decisions.
The staff accountant can be credited with demonstrating professional competence
and due care as he performed his duties as he uncovered material misstatements in the
financial records that had been overlooked during prior reporting cycles. However, the
staff accountant failed to preserve the confidentiality of the employing organisation when
he told his friends and family as the news was not publicly available at the time.
Knowledge Check Question
Question 1
Consider a situation in which a financial reporting manager breaks with company policy by
applying customer receipts to the oldest outstanding invoice regardless of which invoice is
referenced on the payment. He does this to minimise accounts receivable aging, which is
closely monitored by management and is a source of aggravation for him as he is required
to follow up with customers with aged invoices. Explain which of the ethical principles, if
any, are violated in this scenario.
3 . 3 THREATS
This section describes and provides guidance on identifying and evaluating threats that could
consider noncompliance with the Code. Section 3.4: Safeguards, provides guidance on applying
the Code to address these threats.
Section 120.6 of the COE requires professional accountants to consider all circumstances
and relationships that might increase the risk of violation of one or more ethics rules and, thus,
identify those material threats of not being in compliance with the Code. These threats may
arise from a broad range of facts and circumstances; therefore, it is impractical to define every
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possible scenario.
Section 120.6 A 3 of the COE identifies five threats to the ethics fundamental principles
of self-interest threat, self-review threat, advocacy threat, familiarity threat and intimidation
threat. The circumstances of a situation may result in multiple types of threats and impact
multiple fundamental principles.
Section 120.7 provides guidance on evaluating threats and determining an acceptable
level of risk. Professional accountants who have identified a threat to compliance with the
fundamental principles should evaluate whether the threat is at an acceptable level. The COE
defines an acceptable level as ‘a level at which a professional accountant using the reasonable
and informed third party test would likely conclude that the accountant complies with the
fundamental principles’.
Section 120.8 A1 identifies factors relevant in evaluating the level of threats, specifically that
professional accountants shall evaluate any threats to compliance with the ethics fundamental
principles and use quantitative and qualitative factors in evaluating the significance of a threat.
Professionals should also consider conditions, policies and procedures, such as corporate
governance requirements, education, training, experience and existing reporting escalation
channels. Section 120.9 instructs professionals to re-evaluate the threat of an ethical dilemma if
the professional becomes aware of new information or changes in the circumstances.
Section 120.10 of the COE requires professional accountants, who have determined
threats to compliance with the fundamental principles that are at an unacceptable level, to
address threats by eliminating them or reducing them to an acceptable level. Professionals
can eliminate the circumstances creating the threat, decline or end a specific activity, or apply
safeguards. Safeguards are further discussed in Section 3.4.
3.3.1 Self-interest Threat
This is a threat and risk that a member could benefit (financially or otherwise) from an interest
in or relationship with the employing organisation or person affiliated with the employing
organisation, and such financial or other interest could inappropriately influence professional
judgement or the behaviour of accountants.
Illustrative Example 3
Mr. Lee, the CFO of ABC Holdings held a minority ownership interest in the XYZ Hotel
and, therefore, had a personal financial interest in the sale of the hotel. As such, he
faced a self-interest threat to the fundamental principles of ethics. His personal interest
influenced his decisions to facilitate the purchase of the hotel by ABC Holdings and to
omit disclosure of his holdings in the hotel. In evaluating the self-interest threat, the
effective regulatory disclosure requirements and guidance should be considered.
3.3.2 Self-review Threat
This is the threat that a professional accountant will not appropriately evaluate previous or
historical results, on which the accountant will rely in making future decisions.
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Illustrative Example 4
Financial statement reporting involves the identification and inclusion of appropriate
management disclosures. Professional accountants, who are responsible for ensuring
such disclosures are included and are materially complete and accurate, may rely
on the prior and historical disclosures, but they should diligently review whether the
disclosures remain relevant and the details remain complete and accurate. Financial
reporting professionals are less likely to identify issues that have not been previously
raised. Consider a situation in which a financial reporting analyst used the prior period
disclosures to populate the current period disclosures and failed to consider whether
the circumstances underlying a certain disclosure have changed dramatically since the
prior period reporting. The inclusion of the outdated disclosure could be misleading
to investors or otherwise present a misleading message to users of the financial
statements. This situation would present a clear self-review threat.
3.3.3 Advocacy Threat
The advocacy threat causes the member or a professional accountant to promote a
company’s interests to the level and extent that could compromise the member’s objectivity
and independence. An example of such a threat would be a financial reporting accountant’s
employing organisation.
Illustrative Example 5
Consider the professional accountants at ABC Holdings from the Opening Case where
the CFO had a personal financial stake in XYZ Hotel. If the accountants had knowledge
of the conflict of interest or had failed to perform adequate diligence that would have
identified the conflict and did not take steps to include an appropriate disclosure in the
financial offering documents, they would have promoted the interests of ABC Holdings
and the CFO above their responsibility to remain objective.
The accountants failed to ensure the conflict of interest was properly disclosed. They
faced an advocacy threat as they unethically presented incomplete information to be used
in the facilitation of a sale that, if completed, would have provided benefit to the CFO.
3.3.4 Familiarity Threat
Familiarity threat can exist when a member or a professional accountant establishes a cozy
and/or a long-lasting close relationship with their employing company or its management,
or the threat exists such that the member becomes too sympathetic to the company’s or
management’s interests or unjustifiably accepts the work, product or financial representations
of the employing organisation.
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Illustrative Example 6
In the preceding example that described a self-review threat, the accounting team
had used historical disclosures to populate current period reports to the point where
they were comfortable to rely on historical information without adequate diligence to
ensure completeness and accuracy of current financial statements. This situation may
have occurred because a familiarity threat as described in Section 200.6 A1(d) if the
supervising accountant was related to or had a long association with the individuals
responsible for financial statement disclosures.
3.3.5 Intimidation Threat
The undue influence or intimidation threat makes the member subordinate to the professional
judgement of any individual associated with the employing organisation or the person’s
reputation, aggressiveness, expertise or dominance that could unduly influence the member’s
judgement and decision. The influence exerted on the member could be actual or perceived, as
even perceived but not actual influence or intimidation could affect the member’s professional
judgement.
Illustrative Example 7
The professional accountants at ABC Holdings could have faced an intimidation threat
from the CFO of the company that held interests in the XYZ Hotel if the CFO used his
position in the firm to influence the accountants’ behaviour.
Knowledge Check Question
Question 2
The financial reporting department head has insisted to his team that the upcoming
quarterly financial statements should not be delayed. His team only has the time and
resources to use prior period and pro forma information in certain areas of the financial
statements and feels uncomfortable informing the department head of the potential
deficiencies in the reports. Identify the types of potential threats to the fundamental
principles involved.
3 . 4 SAFEGUARDS
The framework states that when the preceding threats occur, members (professional accountants)
must develop and implement safeguards that effectively address the threats and lead the
accountant to make the proper ethical decision. The IFAC and the HKICPA address safeguards
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developed by the profession, legislation or regulation as well as safeguards in the work
environment. As per Section 120.10 and 120.11 of the HKICPA’s COE, depending on the facts and
circumstances, threats can either be removed by eliminating the circumstances creating the threat
or can be addressed by implementing safeguards to reduce the threat to an acceptable level.
Safeguards can be viewed as the control activities that minimise the opportunities and
likelihood of violating ethics codes. They are similar to preventive and detective ‘ethical’
controls. Following are more detailed safeguards at the two most important levels of a
regulatory and employing organisation.
3.4.1 Safeguards Created by the Profession, Legislation or Regulation
Professional, legislative and regulatory safeguards are:
• Education and training requirements on ethics and professional responsibilities;
• Continuing education requirements on ethics;
• Professional standards and the threat of discipline;
• Legislation establishing prohibitions and requirements for entities and employees;
• Competency and experience requirements for professional licensure; and
• Professional resources, such as hotlines, for consultation on ethical issues.
3.4.2 Safeguards in the Work Environment
Employing organisational safeguards are:
• Controls in place to prevent comingling of company assets and personal assets;
• Mandatory training programs on regulatory, industry and company standards and
requirements;
• Oversight functions to monitor activity for adherence with company policies;
• Structural independence of the internal audit function, for example, a reporting
line from internal audit to a board of directors committee and not to a financial
reporting group;
• Operational independence of the internal audit function, for example, auditors are not
to review areas in which they have functional responsibilities;
• Clear and documented compensation and ethics policy;
• Consulting external resources with specific areas of expertise;
• A tone at the top emphasising a commitment to fair financial reporting, a strong
compliance culture and effective corporate governance policies;
• Policies and procedures addressing ethical conduct and compliance with laws, rules and
regulations;
• Audit committee charter, including independent audit committee members, AC
Financial Expert, and so on;
• Internal policies requiring disclosure of identified interests or relationships among the
employing organisation, its directors or officers, and vendors, suppliers or customers;
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• Policies and procedures related to purchasing controls customer acceptance or credit
limits; and
• Controls in place to detect threats to fundamental principles of ethics and to evaluate
the significance of any threats.
Apply and Analyse 2
An internal financial reporting manager of a national bank is responsible for the oversight
of the processes to report remediation plans and the status of existing remediation efforts
to address key audit and compliance issues to the board of directors each quarter. The
manager has worked at the company in various roles for has developed expertise across
multiple bank functions. Though he is a manager in the Financial Reporting Department,
which reports directly to the CFO, he was asked by his prior manager in the compliance
department to help prepare the summary of financial reporting issues for reporting to
the board.
The manager is aware of the compliance policy that prohibits employees from other
departments being involved in the communication of compliance issues. The rule is in
place to ensure the compliance department remains objective and operates without undue
influence from the areas in which they cover. In this situation, the financial reporting
manager ignores this policy because he believes he can help the compliance team and
remain objective. He continues to help his former manager in compliance prepare the
reports for several quarters and does not inform his current supervisor in the Financial
Reporting Department.
Analysis
Safeguards should be implemented or enhanced to prevent breaches to firm policies and
to ensure the compliance function remains independent. Though a company policy is
designed to avoid a conflict of interest or undue influence, there is a lack of oversight to
monitor for adherence with the policy. The lack of effective safeguards led to a conflict of
interest for the financial reporting manager.
Further, though the Financial Reporting Department should report to the CFO, the
scenario illustrates the need for safeguards to ensure employees perform responsibilities
within the scope of their job function. Controls could be implemented to track the work
of auditors, such as requiring all employees to record their time on a weekly or monthly
basis, allocating the time they have worked to specific projects. These time sheets could be
reviewed by management for accuracy and potential conflicts with policy.
3 . 5 PROFESSIONAL ACCOUNTANTS IN BUSINESS
Per Section 200.1-4 of the HKICPA COE, a professional accountant refers to a professional
accountant in business and an individual who is a professional accountant in public practice
when performing professional activities pursuant to the accountant’s relationships with the
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accountant’s firm. This section focuses on professional accountants in business, who can be
employees, contractors, partners, directors, owner-managers or volunteers of an employing
organisation. Professional accountants in business may be solely or jointly responsible for the
preparation and reporting of financial and other information that users of such information
rely on in making their decisions. These users of financial reports are investors, employees,
creditors, governments, regulators or any other users relying on such information.
Professional accountants in business may participate in the preparation of financial
information that is provided to other parties or made publicly available, such as financial
statements, budgets and forecasts. Professional accountants in business are responsible in
preparing such financial information objectively and fairly as well as comply with all applicable
laws, rules, regulations and standards.
3.5.1 Conflicts of Interest
Section 210 of the HKICPA COE covers conflicts of interest. Conflicts of interest can threaten
the objectivity principle or other principles. The threats to the fundamental principles are
created when a professional accountant is involved in an activity in which two or more parties,
such as employers, vendors, customers, lenders or shareholders have conflicting interests.
Professional accountants must not allow conflicts to compromise their judgement. This section
provides guidance on identifying conflicts of interest, the threats created by conflicts, necessary
disclosure and consent requirements, and other considerations.
3.5.1.1 Identifying Conflicts of Interest
Section R210.5 of the Code provides guidance on conflict identification. Professional
accountants must remain alert to changes in any activities, interests and relationships that have
the potential to create a conflict of interest. Professional accountants are required to take all
reasonable steps to identify circumstances that create a threat to the fundamental principle.
This involves continually identifying the nature of relevant interests and relationships of the
parties involved as well as the activities and implications for the parties.
Key Learning Point
When addressing conflicts of interest, professional accountants in business may make
disclosures, share information or seek third-party guidance, and as such, the professional
must remain cognizant of the principle of confidentiality.
3.5.1.2 Threats Created by Conflicts of Interest
As per Section 210.7 of the Code, as a rule of thumb, the closer the connection between the
activity and the matter creating the conflict, the more likely the threat is not at an acceptable
level. Professionals must gather the relevant information and fully understand the facts and
circumstances to evaluate the threats to the fundamental principles.
3.5.1.3 Disclosure and Consent
Section 210.8 includes general information related to the disclosure and consent
considerations related to conflicts of interest. In general, the nature of the conflict of interest
and how any threats were addressed should be disclosed to relevant and appropriate parties.
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Consent of awareness and understanding of an identified conflict of interest can be implied or
in writing. Consent can be implied where professional accountants have adequate evidence
that the parties know the relevant information about the conflict of interests and they have
not raised an objection. If the consent is not in writing, it is best practice for the professional
accountant to document the nature of the conflict of interest, the safeguards to address the
conflict and the consent obtained.
3.5.1.4 Other Considerations
Section 210.9 of the Code recommends that professional accountants seek guidance from
their employing organisation, professional bodies, legal counsel or other accountants when
addressing a conflict of interest.
Illustrative Example 8
The CFO of ABC Holdings had a conflict of interest as he held a personal financial
interest in ABC Holdings and XYZ Hotel. The conflict of interest created the incentive
for the CFO to promote the purchase of the hotel by ABC Holdings for his personal
gain. The professional accountants, operating under the direction and supervision of
the HKICPA COE, should have taken the necessary steps to identify the CFO’s personal
interest in the XYZ Hotel. When the conflict of interest was identified, the professional
accountant(s) involved should have evaluated the threats to the fundamental principles
created by the conflict and taken reasonable steps to mitigate or reduce the threats to an
acceptable level. Steps to address the threat include disclosure and consent as outlined
in Subsections 210.8A1(a) and (b). Specifically, the professional accountant should
disclose the nature of the conflict and how it was addressed to the appropriate levels of
management and obtain consent from the appropriate parties to undertake the activity
posing the threat. Steps to address the threat could also include other safeguards, such
as relying on training and education materials, corporate policies and procedures, or
regulatory requirements and guidance.
3.5.2 Preparation and Reporting of Information
This section covers the preparation and presentation of information. Detailed requirements
and application guidance is provided in Section 220 of the HKICPA COE. Specifically, following
information in this section will provide guidance and information related to the relevant
stakeholders, examples of reports methods professional accounts should adopt, the use of
discretion, documentation and how to address potentially misleading information.
The stakeholders to or for whom such information is prepared or presented is described in
Section 220.3.A2 of the Code as the following:
• Management and those charged with governance;
• Investors and lenders or other creditors; and
• Regulatory bodies.
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Examples of reports are included in Section 220.3.A2 of the Code:
• Operating and performance reports;
• Decision support analyses;
• Budgets and forecasts;
• Information provided to the internal and external auditors;
• Risk analyses;
• General and special purpose financial statements;
• Tax returns; and
• Reports filed with regulatory bodies for legal and compliance purposes.
Section 220.4 of the Code specifies how a professional accountant in business should
handle these situations. Professional accountants in business are required to prepare or
present information in accordance with the relevant reporting framework and in a manner not
intended to mislead or influence outcomes inappropriately. Professional accountants must
exercise professional judgement to represent the facts completely and accurately, to describe
the true nature of the activity, and to prepare or present information in a timely manner.
Professional accountants’ use of discretion in preparing and presenting information is
guided by Section 220.5 of the Code. Professional accountants may be required to exercise
discretion in making professional judgements. No discretion can be applied with the intention
of misleading or influencing outcomes inappropriately. Determining estimates, selecting an
accounting policy, and determining the timing, structure and disclosures of transactions are all
decisions that may require professional judgement where the professional accountant has the
ability to influence the outcome of a transaction or activity.
A professional accountant may become aware of or suspect that information is misleading,
and in such a situation, the accountant is responsible for taking the appropriate actions to
resolve the issue. This section provides guidance on how to address information that might be
misleading per Sections 220.8 and 9 of the Code. Professional accountants are provided with
three appropriate actions to address the issue, including correcting the information, disclosing
the issue to users, providing them with corrected information and/or following guidance
provided by the employing organisation. If the accountant believes the issue is persisting, he
should consult with relevant professional bodies, internal or external auditors, or legal counsel.
If the issue still persists, the professional accountant should consider withdrawing from
involvement in the report or resigning from the employing organisation.
Per Section 220.10 of the Code the professional accountant is encouraged to document the
following in the event of a threat to compliance with the fundamental principles:
• The facts;
• The accounting principles or other relevant professional standards involved;
• The communications and parties with whom matters were discussed;
• The courses of action considered; and
• How the accountant attempted to address the matter(s).
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Key Learning Point
Section 220 of the HKICPA’s COE addresses preparation and reporting information by
professional accountants in business that may be made public or used by others outside
or inside their organisation. Professional accountants must prepare and present such
information (e.g. financial or management information, financial statements, budgets,
forecasts) fairly, honestly and in compliance with applicable professional standards.
3.5.3 Acting with Sufficient Expertise
Section 230 of the HKICPA COE states that professional accountants in business should
have or obtain sufficient expertise, knowledge and training in performing professional
services. Specifically, professional accountants are required to comply with the fundamental
principles and act with sufficient expertise to avoid self-interest threats to compliance with the
professional competence and due care principles. These principles help to ensure that only
tasks for which the accountant has sufficient expertise are undertaken by the accountant.
Professional accountants should have a clear understanding of the limits of their expertise, and
they should not intentionally mislead an employing organisation as to their level of expertise.
The threat to professional competence or due care could be created if insufficient time
is allocated to complete a task, incomplete or inadequate information or other resources are
available, or insufficient training or experience by the accountant. To evaluate a threat to the
principles, an accountant should consider the level of involvement by others, the accountant’s
seniority and the level of supervision applied.
Professional accountants should obtain assistance or training where necessary and ensure
adequate time exists to perform the task. If the threat to the principles cannot be reduced to an
acceptable level, the accountant should consider declining the assignment.
Key Learning Point
Lack of proper competency in performing duties can cause threats of noncompliance with
fundamental principles, and professional accountants should develop safeguards to eliminate
such threats, including obtaining expertise or refusing to accept such engagements.
3.5.4 Financial Interests, Compensation and Incentives Linked
to Financial Reporting and Decision Making
Accounting firms consist of diverse individuals with a variety of value systems and ethical
backgrounds. Individuals (e.g. accountants) in an accounting firm work in collaboration and
coordination with others in fulfilling their responsibilities. Gamesmanship, loyalty, peer
pressure and other factors influence people’s ethical decisions and actions and can create
conflicts of interest. Conflicts of interest and related incentives can cause professional
accountants to behave either ethically or unethically. Examples of ethics incentives are an
organisation’s appropriate tone at the top promoting ethical conduct, various professional
codes of conduct (e.g. IFAC and HKICPA Code) and ethics rules.
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Section 240 of the HKICPA COE sets out the specific requirements and application guidance
for professional accountants who have a financial interest or have close family members who
have a financial interest that creates a self-interest threat to compliance with the principles
of objectivity and confidentiality. The Code specifically prohibits professional accountants
from manipulating information or using confidential information for personal gain or the gain
of others.
Various scenarios could create a self-interest threat for a professional accountant or a close
family member, including having the opportunity to manipulate information to gain financially,
holding a direct or indirect financial interest in the employing organisation, being eligible for
profit-related bonuses, holding deferred bonus share rights or share options in the employing
organisation, or participating in compensation schemes in which the accountant is motivated to
prioritise achieving certain targets that affect his compensation above other goals.
Professional accountants should consider the following factors when evaluating threats to
the fundamental principles:
• The significance of the financial interest;
• Policies and procedures for a committee independent of management to determine the
level or form of senior management remuneration;
• Disclosure to those charged with governance of
°° All relevant interests
°° Any plans to exercise entitlements or trade in relevant shares; and
• Internal and external audit procedures specific to address issues that give rise to the
financial interest.
Key Learning Point
Having financial interests in their employing organisation may create threats to compliance
even though fundamental principles and safeguards should be designed to address these
threats.
Apply and Analyse 3
Mr. Chan is the financial reporting manager of HKG Financial Ltd (HKG), a Hong Kong-based
public financial services firm. Mr. Chan is responsible for quarterly financial reporting,
including the associated disclosures. Mr. Chan and his wife, Mrs. Chan, are personally
invested in HKG. Together, approximately 15% of their net wealth is invested in the
company. Mr. Chan, being a professional accountant and having worked for the company
for several years, is aware of the impact of changes in the company’s share price on his
personal financial position.
As Mr. Chan and his team prepare the prior quarter financial reporting package,
he becomes aware of irregularities in the documentation supporting sales receipts and
invoices near prior quarter-end. Specifically, he identifies that not all sales receipts are
supported by complete documentation, such as invoices and bank deposits, but all
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Apply and Analyse 3 (continued)
have been recorded in the full amount, effectively overstating quarterly income. The
discrepancies have been charged to a temporary adjustment account.
In aggregate, the over-reporting of income amounted to approximately 5% of the prior
quarter’s sales and was limited to three clients. As prepared, the prior quarter financial
report indicates that several key targets were narrowly achieved, which will trigger financial
awards to key management personnel. The manager is aware that he is eligible for the
award along with the company executives and the department heads.
Analysis
As the financial reporting manager, Mr. Chan identifies the situation as a clear breach
of accounting principles and a threat to the ethical principles. Specifically, the situation
presents a self-interest threat because if he were to not report the accounting error, he
would risk compromising his objectivity by putting the company’s and his own personal
short-term interests over his responsibility to report and correct the error.
Before deciding on his next steps, Mr. Chan considers the materiality and potential
consequences of reporting or not reporting the issue. He determines the threat to ethical
principles is above an acceptable level as the over-reporting revenues would amount to
a material misstatement in the financial reports. Such a misstatement would likely result
in severe reputational damage to himself, his company and the professional accountant
profession. It could also lead to regulatory scrutiny including fines.
3.5.5 Inducements
This section provides an overview of the requirements and application guidance on inducements
from the HKICPA Code as well as the Prevention and Bribery Ordinance (POB Ordinance) in
Hong Kong.
Section 250 of the HKICPA Code defines inducements as ‘an object, situation, or action
that is used as a means to influence another individual’s behaviour, but not necessarily with the
intent to improperly influence that individual’s behaviour’. Professional accountants in business
must understand and comply with the fundamental principles of ethics and the applicable laws
and regulations, such as those around bribery and corruption. Accountants, in normal course
of business, offer or accept inducements and those inducements may create self-interest,
familiarity, or intimidation threats to the fundamental principles.
Inducements can include the following examples:
• Gifts;
• Hospitality;
• Entertainment;
• Donations;
• Career or business opportunities; and
• Preferential treatment.
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The POB Ordinance in Hong Kong (Cap.201) includes requirements and guidance related
to inducements for professional accountants in Hong Kong. Specifically, the POB Ordinance
governs the acceptance of any gift, loan, fee, commission, employment, or favour by individuals
in an agent-principal relationship. The best practice for professional accountants in business
is to seek permission from an appropriate group, such as management, compliance or a
regulator and refer to the applicable laws and regulations prior to accepting or offering any
inducements.
Key Learning Point
Professional accountants shall not offer inducements to improperly influence the
judgement of a third party, and if pressure to do so comes from their employer, the
accountant should document the situation and inform senior management. The
accountant should consider various factors in each situation, such as the nature,
value, timing and recipient of the inducement as well as cultural and corporate policy
considerations.
Knowledge Check Question
Question 3
Identify the steps a professional accountant in business could take in a scenario in which
the accountant believes material omissions are in a financial report.
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SUMMARY
• There are five fundamental principles of ethics for professional accountants:
1. Integrity – To be straightforward and honest in all professional and business relationships.
2. Objectivity – To compromise neither professional nor business judgements because of
bias, conflict of interest or undue influence of others.
3. Professional Competence and Due Care – to:
i. Attain and maintain professional knowledge and skill at the level required to ensure
an employing organisation receives competent professional service, based on current
technical and professional standards and relevant legislation; and
ii. Act diligently and in accordance with applicable technical and professional standards.
4. Confidentiality – To respect the confidentiality of information acquired because of
professional and business relationships.
5. Professional Behaviour – To comply with relevant laws and regulations and avoid any
conduct that the professional accountant knows or should know might discredit the
profession.
• Five categories of threats exist to ensure compliance with the fundamental principles:
1. Self-interest threat – The threat that a financial or other interest will inappropriately
influence a professional accountant’s judgement or behaviour;
2. Self-review threat – The threat that a professional accountant will not appropriately
evaluate the results of a previous judgement made; or an activity performed by
the accountant, or by another individual within the accountant’s firm or employing
organisation, on which the accountant will rely when forming a judgement as part of
performing a current activity;
3. Advocacy threat – The threat that a professional accountant will promote an employing
organisation’s position to the point that the accountant’s objectivity is compromised;
4. Familiarity threat – The threat that due to a long or close relationship with an employing
organisation, a professional accountant will be too sympathetic to their interests or too
accepting of their work; and
5. Intimidation threat – The threat that a professional accountant will be deterred from acting
objectively because of actual or perceived pressures, including attempts to exercise undue
influence over the accountant.
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• Safeguards are actions, individually or in combination, the professional accountant takes that
effectively reduce threats to compliance with the fundamental principles to an acceptable
level. Such safeguards are the following:
°°If the professional accountant determines the identified threats to compliance with the
fundamental principles are at an unacceptable level, the accountant shall address the
threats by:
i. Eliminating the circumstances, including interests or relationships, that are creating
the threats;
ii. Applying safeguards, where available and capable of being applied, to reduce the threats
to an acceptable level, or
iii. Declining or ending the specific professional activity.
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MIND MAP
INTRODUCTION TO BUSINESS ETHICS PROFESSIONAL ACCOUNTANTS IN BUSINESS
The International Ethics Standards Board Conflicts of Interest
for Accountants (IESBA) Prepatation and Reporting of Information
HKICPA Code of Ehics Acting with Sufficient Expertise
ETHICS FUNDAMENTAL PRINCIPLES Financial lnterests, Compensation and
Integrity– To be straight forward and honest Incentives Linked to Financial Reporting
and Decision Making
Objectivity– Not to compromise judgements CODE OF ETHICS Inducements
Professional Competence and Due FOR PROFESSIONAL
Care - Maintain professional knowledge ACCOUNTANTS SAFEGUARDS
and skills Safeguards Created by the Profession,
Confidentiality–To respect the confidentiality Legislation or Regulation
of information Safeguards in the Work Environment
Professional Behaviour –To maintain the
reputation of the profession.
THREATS
Self-interest threat–Inappropriate influence
on judgement
Self-review threat–Inappropriate reliance on
results of a previous judgement
Advocacy threat– Promotion of a position
that compromises objectivity
Familiarity threat–Too sympathetic to other
interests
Intimidation threat– Deterred from acting
objectively because of pressures
Answers to Knowledge Check Questions
Question 1
Integrity, objectivity, professional competence and due care are the ethical principles
violated in the scenario. The accountant failed to act with integrity and with objectivity as
he knowingly misapplied payments to his own benefit.
Further, the professional competence and due care principle was violated by the
accountant as the payments were not correctly accounted.
Question 2
The types of potential threats to the fundamental principles are self-review and
intimidation threats.
Question 3
Step 1: Correct the information.
Step 2: Disclose the issue to users and provide them with corrected information; and/or
Step 3: Follow guidance provided by the employing organisation.
a. If the accountant believes the issue persists, he should consult with relevant
professional bodies, internal or external auditors, or legal counsel.
b. If the issue persists, the professional accountant should consider withdrawing from
involvement in the report or resigning from the employing organisation.
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EXAM PRACTICE
QUESTION 1
A professional accountant in the Financial Reporting Department is authorised to hire a
vendor to support his department’s training program. His uncle is a retired business and
accounting professor, and he submits a proposal to be the training facilitator. Though his
uncle has relevant experience in business and teaching a class, he does not believe his uncle
has the specific expertise required and the accountant is aware of other more qualified
individuals.
He is directly pressured by his uncle and other family members to accept his uncle’s
proposal to work as a vendor for the company. His family is close-knit, and he wants to avoid
disappointing them. He understands that hiring his uncle over more qualified applicants is
unethical and would reflect poorly on his professional judgement, but ultimately, he feels
compelled to help his uncle. The accountant does not inform his employing organisation of
his conflict of interest and accepts his uncle’s proposal.
(a) Identify the violations to relevant fundamental principles.
(b) Identify the relevant threat or threats in the case.
(c) Identify factors that should be considered when evaluating the threats in the case.
(d) Recommend next steps for the professional accountant.
ANSWERS TO EXAM PRACTICE
QUESTION 1
(a) The professional accountant violated the following principles:
• Integrity. The accountant knowingly omitted relevant information when advocating
for the company’s acceptance of his uncle’s proposal.
• Objectivity. The accountant allowed his relationship with and pressure from his
uncle to influence his professional judgement.
• Professional competence and due care. As his uncle is less than fully qualified to
perform the services, the accountant failed to take reasonable steps to ensure the
vendors have the appropriate level of skills, experience and training.
(b) Intimidation, self-interest and familiarity threats. The case involved an intimidation
threat to compliance with the fundamental principles as the accountant felt pressured
and compelled to advocate for his uncle’s proposal. A self-interest threat existed as he
served his own interests in appeasing his family members ahead of the interest of the
company. A familiarity threat existed as his close relationship with his uncle and other
family members led him to unjustifiably accepting the uncle’s proposal.
(c) The following factors should be considered:
• The intent of the individual who is exerting the pressure and the nature and extent
of the pressure.
• The application of laws, regulations and professional standards to the
circumstances.
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• The culture and leadership of the employing organisation.
• Policies and procedures, if any, that the employing organisation has established.
(d) The professional accountant should consider the following actions:
• Discuss the matter with the individual who is exerting the pressure to seek to
resolve it.
• Discuss the matter with the accountant’s superior.
• Escalate the matter within the employing organisation.
• Disclose the matter in line with the employing organisation’s policies.
• Consult with a legal counsel, regulatory body, colleague, superior, human resources
personnel or another professional accountant.
• Document the nature of the circumstances, safeguards applied and
consent obtained.
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Part C
Appropriate Accounting Principles
and Concepts to Account for
Business Transactions
Chapter 4 Fair Value Measurement
Chapter 5 Revenue
Chapter 6 Inventories
Chapter 7 Property, Plant and Equipment
Chapter 8 Investment Property
Chapter 9 Leases
Chapter 10 Borrowing Costs
Chapter 11 Intangible Assets
Chapter 12 Financial Assets, Financial Liabilities and Equity Instruments
Chapter 13 Hedge Accounting
Chapter 14 Impairment of Assets
Chapter 15 Non-current Assets Held for Sale and Discontinued Operations
Chapter 16 Accounting Policies, Changes in Accounting Estimates and Errors
Chapter 17 Events after the Reporting Period
Chapter 18 Provisions, Contingent Liabilities and Contingent Assets
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Chapter 19 Income Taxes
Chapter 20 Earnings per Share
Chapter 21 Related Party Disclosures
Chapter 22 Government Grants
Chapter 23 Employee Benefits
Chapter 24 Share-based Payments
Chapter 25 Operating Segments
Chapter 26 O
ther Business Transactions, including
Agriculture and Biological Assets, Insurance Contracts,
Mineral Resources and Service Concession Arrangements
Chapter 27 Financial Statements for an Individual Entity
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4
Fair Value
Measurement
CHAPTER TOPIC LIST
4.1 Overview 4.4 Fair Value at Initial Recognition
4.1.1 Scope
4.5 Valuation Techniques
4.1.2 Definition of Fair Value
4.5.1 Market Approach
4.2 Measurement Approach 4.5.2 Cost Approach
4.2.1 Asset or Liability 4.5.3 Income Approach
4.2.2 The Transaction
4.6 Inputs to Valuation Techniques
4.2.3 Market Participants
4.6.1 Bid and Ask Prices
4.2.4 The Price
4.6.2 Premiums and Discounts
4.3 Application of Fair Value 4.6.3 Fair Value Hierarchy
4.3.1 Non-financial Assets: Highest
4.7 Disclosure
and Best Use
4.3.2 Application to Liabilities and an
Entity’s Own Equity Instruments
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LEARNING OUTCOMES
PRINCIPAL LO2: APPLY APPROPRIATE ACCOUNTING PRINCIPLES AND CONCEPTS TO ACCOUNT
FOR BUSINESS TRANSACTIONS
LO2.10: D
escribe and account for business transactions in accordance with Hong Kong Financial
Reporting Standards as they relate to: Fair value measurement
2.10.01 Explain concepts and principles in relation to fair value measurement, including definition
of fair value, principal market, most advantageous market and market participants
2.10.02 Determine an appropriate valuation technique in measuring the fair value of an asset or
a liability item
2.10.03 Determine appropriate inputs to valuation techniques in measuring the fair value of an item,
with reference to the fair value hierarchy
2.10.04 Apply the valuation approach to measure the fair value for key financial and non-financial
assets and liabilities
2.10.05 Prepare disclosures in respect of fair value measurements
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OPENING CASE
HK PROPERTY DEVELOPMENT
H K Property Development Ltd (HKPD) is a leading property development and investment
company with a particular focus on Hong Kong and mainland China. The company is
based in Hong Kong and listed on the Stock Exchange of Hong Kong. It develops residential
and commercial properties, including skyscrapers, houses, townships, hotels, shopping centres
and resorts.
HKPD’s business is vertically integrated with project management, construction, property
management and financial services supporting its core business of property development and
investment.
Since its incorporation in 2010, HKPD has been going through significant growth and
has made a number of substantial acquisitions over the last few years, helping it to position
itself as a leading player in the Asia-Pacific region with a market capitalisation of just over
HK$400 billion.
As part of a business acquisition during the year, HKPD acquired a large parcel of land
(Land A), which is currently being developed for industrial use as a site for a factory. HKPD
also acquired a company (Company C) that sells a range of construction supplies mainly in the
Hong Kong market although it sells supplies occasionally in the Singaporean and Malaysian
markets. In addition, HKPD recently acquired a block of land (Land B) from the government in a
separate transaction.
In addition to property development, HKPD invests its surplus cash in listed shares and
unlisted derivatives.
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OVERVIEW
The use of fair value has become more prevalent over the last decade. A number of HKASs and
HKFRSs require or permit entities to measure or disclose the fair value of assets, liabilities or
their own equity instruments. Prior to the issuance of IFRS 13 Fair Value Measurement (HKFRS 13
Fair Value Measurement) in 2011, the requirements relating to measurement of fair value and
disclosure of fair value information were dispersed across several standards and were not
always consistent across those standards as a result of those requirements having evolved over
many years.
HKFRS 13 defines ‘fair value’ and sets out a single framework for its measurement and
required disclosures. It applies to almost all fair value measurements and fair value-based
measurements, on initial recognition and on subsequent measurement (if fair value is required
or permitted by other HKASs or HKFRSs).
HKFRS 13 addresses the question of how to measure fair value rather than when to
measure fair value or what to measure at fair value. In other words, the standard only
applies when other HKFRSs require or permit fair value measurement in the primary financial
statements or in the notes. For example, HKFRS 13 applies when an entity elects to revalue
its property, plant and equipment at fair value in accordance with the revaluation model in
HKAS 16 Property, Plant and Equipment.
The core principle in HKFRS 13 is that fair value is a market-based measurement, not an
entity specific measurement. So, when measuring fair value, the entity uses the assumptions
that market participants would use when pricing the asset or liability under current market
conditions, including assumptions about risk. Therefore, an entity’s intention to hold an asset
or settle a liability is irrelevant when measuring fair value.
The aim of this chapter is to provide you with a sound understanding of the key principles
in HKFRS 13 and how they are applied in practice. The chapter is not intended to deal with
complex valuation issues.
4 . 1 OVERVIEW
In this section, you will gain an understanding of the fair value measurement and disclosure
requirements subject to HKFRS 13 requirements and those that fall outside its scope. In
addition, you will be introduced to some of the key terminology used in HKFRS 13.
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4.1.1 Scope
HKFRS HKFRS 13 applies when another HKFRS requires or permits fair value measurements or
13.5–7 disclosures about fair value measurements, with the exceptions listed in Exhibit 4.1.
Measurement and disclosure Disclosure requirements in HKFRS 13
requirements in HKFRS 13 do not apply to do not apply to
Plan assets measured at fair value
Share-based payments (HKFRS 2)
in accordance with HKAS 19
Retirement benefit plan investments measured
Leases (HKFRS 16)
at fair value in accordance with HKAS 26
Measurements that have similarities to fair value
Assets for which recoverable amount is fair value
such as net realisable value (HKAS 2) or value in
less costs of disposal in accordance with HKAS 36
use (HKAS 36)
EXHIBIT 4.1 Fair value measurement and/or disclosure requirements outside the scope
of HKFRS 13
HKFRS
The principles set out in HKFRS 13 apply to the initial and subsequent measurements if fair
13.8 value is required or permitted by other HKASs or HKFRSs.
4.1.2 Definition of Fair Value
Fair value is defined in the HKFRS as the price that would be received to sell an asset or paid to
HKFRS transfer a liability in an orderly transaction between market participants at the measurement
13.9 date.
4 . 2 MEASUREMENT APPROACH
The standard explains that fair value measurement requires an entity to determine:
• The particular asset or liability being measured;
• The market in which an orderly transaction would take place;
• The highest and best use for the asset and whether that asset is used in combination
with other assets or on a stand-alone basis for non-financial assets; and
• The appropriate valuation technique to use, while minimising unobservable inputs and
maximising relevant observable inputs.
The transaction referred to in the definition of fair value is a hypothetical transaction.
In other words, an entity is to assume that a hypothetical transaction to sell an asset or transfer
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a liability takes place at the measurement date. This is regardless of whether the entity intends
to sell the asset or transfer the liability and whether the entity has the ability to enter into the
transaction at the measurement date.
4.2.1 Asset or Liability
When determining fair value, it is important to be clear on the particular asset or liability that is
the subject of fair value measurement. The standard requires entities to account for the asset
HKFRS or liability characteristics when measuring fair value if market participants would take those
13.11 characteristics into account when pricing the asset or liability at the measurement date.
Examples of such characteristics include the condition and location of the asset and
restrictions (if any) on the sale or use of the asset. The effect of restrictions (contractual
or other legal restrictions) on fair value measurement will vary depending on whether the
restriction would be taken into account by market participants when pricing the asset. For
example, a legal restriction that is specific only to the current owner of the asset (and not
applicable to market participants in general) will not affect the asset’s fair value.
Illustrative Example 1
HKPD’s block of land (Land B) sits adjacent to one of HKPD’s major residential apartment
developments. HKPD is permitted to use Land B only for building and operating a
community leisure centre. Upon review of the relevant documentation, HKPD determines
the restriction on the use of the land would not be transferred to market participants if
HKPD sells the land. The land is also subject to an easement providing utility companies
the legal right to run gas, electricity and telephone lines across the land.
HKPD concludes that the restriction on HKPD to use the block of land only for building
and operating a community leisure centre will not be reflected in the fair value of the land
because the restriction is specific to HKPD and, therefore, would not be transferred to
market participants upon sale of the land.
However, the restriction relating to the easement on the land will be reflected in
the fair value of the land as it is a characteristic of the land and will pass on to market
participants upon sale.
The fair value measurement of an asset or liability might be:
• On a stand-alone basis (e.g. a financial instrument); or
• As part of a group of assets, group of liabilities or group of assets and liabilities
(e.g. a cash-generating unit).
Whether the measurement takes place on a stand-alone basis or as part of a group for
initial recognition, subsequent measurement or disclosure purposes depends on the unit of
account. The unit of account is defined in the Conceptual Framework as the right or group of
rights, the obligation or group of obligations, or the group of rights and obligations, to which
recognition criteria and measurement concepts are applied. Generally, accounting standards
will specify the unit of account. For example, the unit of account for HKPD’s investments in
shares will be each individual share as specified in HKFRS 9 Financial Instruments.
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The unit of account for the asset or liability is determined in accordance with the HKFRS
that requires or permits the fair value measurement. Exhibit 4.2 includes some examples.
Stand-alone asset/liability A share in a publicly listed company or a derivative
instrument (HKFRS 9)
Group of assets A cash-generating unit (HKAS 36) or a portfolio of receivables
(HKFRS 9)
Group of liabilities A portfolio of deposits held by a financial institution (HKFRS 9)
Group of assets and liabilities A cash-generating unit (HKAS 36) or a disposal group (HKFRS 5)
EXHIBIT 4.2 Examples of unit of account considerations in accordance with HKFRSs
4.2.2 The Transaction
As previously explained, when applying HKFRS 13, an entity assumes that a hypothetical
transaction takes place at the measurement date irrespective of whether the entity has the
intention and/or the ability to enter into an actual transaction to sell an asset or transfer a
liability. Such a hypothetical transaction is assumed to be:
• An orderly transaction;
• Between independent, knowledgeable and willing markets participants with the ability
to enter into the transaction;
• In the principal or most advantageous market;
• Under current market conditions; and
HKFRS
13.15–16 • At the measurement date.
HKFRS 13 defines an orderly transaction as a transaction that assumes exposure to
the market for a period before the measurement date to allow for marketing activities that
are usual and customary for transactions involving such assets or liabilities; it is not a forced
transaction (e.g. a forced liquidation or distress sale).
This means there needs to be adequate market exposure for the market participants to
be sufficiently knowledgeable about the asset or liability. The period of time necessary for
the usual and customary marketing or market exposure would depend on the particular
circumstances. For example, for the HKPD’s Land B, a period of three to six months might be
necessary for adequate market exposure.
Illustrative Example 2
HKPD purchased its Land A from ABC Limited (ABC) as part of a business combination
transaction. As ABC was in significant financial difficulty at the time and was compelled
to sell the business within a short period, HKPD was able to purchase the business at a
much lower price. The acquisition agreement had allocated HK$3.5 million for Land A
whereas the land could be sold for HK$5 million with adequate market exposure. Given
the requirement in HKFRS 3 Business Combinations to initially recognise the land at fair
value, HKPD recorded Land A at HK$5 million as it represented the land’s fair value in an
orderly transaction in accordance with HKFRS 13.
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In determining fair value, an entity assumes the orderly transaction between the market
participants takes place in either:
• The principal market for the asset or liability; or
HKFRS • The most advantageous market for the asset or liability (if there no principal
13.16 market exists).
HKFRS
13. App. A Exhibit 4.3 explains the difference between principal and most advantageous markets.
Principal market
The market with the greatest volume and level of activity for
the asset or liability
Most advantageous market
The market that maximises the amount that would be received
to sell the asset or minimises the amount that would be paid to
transfer the liability, after taking into account transaction costs
and transport costs
EXHIBIT 4.3 Principal market versus the most
advantageous market
Entities do not need to undertake an exhaustive search of all possible markets to identify
the principal market or the most advantageous market, however, entities need to take into
account all reasonably available information. There is a general presumption that the market in
which an entity would normally enter into a transaction to sell the asset or transfer the liability
is the principal market in the absence of evidence to the contrary.
In practice, when determining the principal market, an entity first determines the markets
accessible to the entity at the measurement date. It then considers the markets that have
the greatest volume and level of activity for the specific asset or liability being measured.
The volume and level of activity is based on the activity for the specific asset or liability in the
market (including other sellers) rather than on the volume or activity of the entity’s transactions
(i.e. an entity specific measure) in a particular market.
The assessment of whether a particular market is accessible is made from the specific
entity’s perspective. For example, for Company C referred to in the opening case, the
accessible markets would be considered to be Hong Kong, Singapore and Malaysia even
if there are other markets around the world providing higher prices for Company C’s
construction supplies.
The most advantageous market is defined as the market that maximises the amount that
would be received to sell the asset or that minimises the amount that would be paid to transfer
the liability, after taking into account transaction costs and transport costs.
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HKFRS 13 defines transaction costs as the costs to sell an asset or transfer a liability in the
principal (or most advantageous) market for the asset or liability that are directly attributable to
the disposal of the asset or the transfer of the liability and meet the following criteria:
• They result directly from and are essential to that transaction; and
• They would not have been incurred by the entity had the decision to sell the asset or
transfer the liability not been made.
HKFRS 13 defines transport costs as the costs that would be incurred to transport an asset
from its current location to its principal (or most advantageous) market.
An entity only needs to identify its most advantageous market if there is no principal
market for the asset or liability (e.g. if information on the principal market is unavailable).
If a principal market exists, the price in the principal market must be used in the fair value
measurement even if the price in another market is more advantageous.
When determining the most advantageous market, an entity considers transaction costs
and transport costs. However, as noted in Section 4.2.4, transaction costs are excluded from
fair value measurement because transaction costs are not considered to be a characteristic of a
particular asset or liability.
Illustrative Example 3
Entity Z (Z) is seeking to estimate the fair value an asset for which no principal market
exists. It has two possible markets:
Market 1 Market 2
HK$ HK$
Price that would be received 500,000 490,000
Transaction costs (50,000) (30,000)
Transport costs (20,000) (25,000)
Net proceeds 430,000 435,000
Z identifies Market 2 as the most advantageous market for the asset because the
amount received in Market 2 (HK$435,000) is higher than in Market 1 (HK$430,000) after
taking into account transaction costs and transport costs. Accordingly, the fair value of the
asset is HK$465,000 (HK$490,000 − HK$25,000). Transaction costs are not considered to be
a characteristic of the asset as explained in Section 4.2.4.
Although Market 1 provides a higher fair value for the asset of HK$480,0000
(HK$500,000 − HK$20,0000), it is disregarded for fair value measurement purposes
because Market 2 is assessed as the most advantageous market (providing net proceeds of
HK$435,000 compared to HK$430,000 in Market 1).
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4.2.3 Market Participants
Fair value of an asset or liability is to be measured using the assumptions that market
HKFRS participants would use when pricing the asset or liability assuming that market participants act
13.22 in their economic best interest.
HKFRS 13 defines market participants as buyers and sellers in the principal (or most
advantageous) market for the asset or liability that have all of the following characteristics:
• They are independent of each other, that is, they are not related parties as defined in
HKAS 24 although the price in a related party transaction may be used as an input to a
fair value measurement if the entity has evidence that the transaction was entered into
at market terms;
• They are knowledgeable, having a reasonable understanding about the asset or liability
and the transaction using all available information, including information that might be
obtained through due diligence efforts that are usual and customary;
• They are able to enter into a transaction for the asset or liability; and
• They are willing to enter into a transaction for the asset or liability, that is, they are
motivated but not forced or otherwise compelled to do so.
In developing the assumptions that market participants would use when pricing the asset
HKFRS or liability, identifying specific market participants is unnecessary. The entity simply needs to
13.23 identify characteristics that distinguish market participants more generally, considering factors
specific to the following:
• The asset or liability;
• The principal (or most advantageous) market for the asset or liability; and
• Market participants with whom the entity would enter into a transaction in that market.
The determination of market participants is not always a significant practical issue. When
there is a quoted price in an active market, an entity must use that price and there would be no
need to consider who the market participants are, provided the entity has identified the correct
market. HKFRS 13 defines an active market as a market in which transactions for the asset or
liability take place with sufficient frequency and volume to provide pricing information on an
ongoing basis.
If there is an observable market with a range of observable prices, some of the pricing
information may relate to transactions that are irrelevant to the measurement of fair value
(e.g. related party transactions or distressed sales). In some cases, there may be no observable
market and as a result valuation may require the use of significant non-observable inputs.
In such situations, the entity will need to give more thought as to who the potential market
participants are so assumptions can be made about how those market participants would price
the asset and liability.
Exhibit 4.4 highlights the importance of identifying market participants in the spectrum of
fair value inputs.
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Hypothetical Are all the prices
market/market ‘fair value
participants relevant’?
Inactive market or no Observable market Active market with
observable market with range of prices observable prices
Critical Not important
EXHIBIT 4.4 Importance of considering market participants
Apply and Analyse 1
HKPD’s assets include the following:
(a) Land A, which is currently being developed for industrial use as a site for a
factory. Nearby sites have recently been developed for residential use as high rise
apartment buildings in light of the booming residential property market in Hong
Kong. With recent zoning and other changes, HKPD believes Land A could now be
developed as a site for residential apartments.
(b) Land B which was acquired from the government in a separate transaction
(c) Listed shares and unlisted derivatives
Required:
(a) Discuss the importance of considering market participants for each of HKPD’s
assets listed above.
(b) Identify likely market participants where the consideration of market participants is
considered important in part (a).
Analysis
(a) Consideration of market participants would be important for Lands A and B
because land is a unique asset, and as such, there will be no active market and
no observable market with a range of prices for identical parcels of land. On the
other hand, for listed shares, HKPD does not need to consider who are the market
participants. This is because HKPD must use a quoted price in an active market.
Unlisted derivatives are over-the-counter (OTC) derivatives, which do not have
quoted prices for identical instruments. Accordingly, consideration needs to be
given to who the relevant market participants are for these instruments.
(b) Because HKFRS 13 defines the principal market for an asset to be the market with
the greatest volume and level of activity for the asset, most market participants
would likely be other organisations within the same industry as the entity. Given
the potential for industrial and residential use, the market participants for Lands
A and B are likely to be other entities operating in the industrial and residential
apartment markets in Hong Kong. For unlisted derivatives, market participants
are likely to be other OTC market participants for such derivatives (which are
commonly used as hedging instruments).
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4.2.4 The Price
It is important to recognise that fair value represents an exit price under HKFRS 13. The
HKFRS exit price is defined as the price that an entity would receive to sell an asset or pay to transfer
13 App. A a liability. This is in contrast to an entry price, which is defined in HKFRS 13 as the price paid to
acquire an asset or received to assume a liability in an exchange transaction.
When determining fair value, an entity does not need to adjust the price in the principal
(or most advantageous) market for transaction costs because transaction costs are not
considered to be a characteristic of a particular asset or liability. Transaction costs are specific
HKFRS to a transaction (e.g. due diligence costs) and will vary depending on how an entity enters into
13.25 a transaction for the asset or liability.
However, transport costs are not considered to be transaction costs. Where the location is a
characteristic of the asset (e.g. a commodity), the price in the principal (or most advantageous)
HKFRS market is adjusted for costs necessary to transport the asset from its current location to
13.26 that market.
Apply and Analyse 2
Entity Z (Z) is a company that holds an asset, which is sold in two different markets at
different prices. The details of each market are provided in the table below:
New York market London market
Total daily sales by sellers of the asset 100,000 20,000
HK$ HK$
Price per unit 100 108
Transport costs per unit (5) (14)
Transaction costs per unit (4) (1)
Net 91 93
Required:
(a) Determine the fair value per unit.
(b) Identify how your answer would differ if there was no principal market.
Analysis
(a) The principal market is New York because it has the greatest volume and level of
activity. Since Z has access to that market and it has the greatest level of activity,
the fair value determined in accordance with the New York market is HK$95
(HK$100 per unit less transport costs of HK$ 5). By stating that the asset is currently
sold in New York and London markets, the question implies that Z has access to
both of these markets.
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Apply and Analyse 2 (continued)
(b) The most advantageous market is London because it has the highest net proceeds
(HK$93 in London versus HK$91 in New York). As explained in Section 4.2.2, when
determining the most advantageous market, Z takes into account transaction
and transport costs. However, transaction costs are excluded from fair value
measurement as transaction costs are not considered to be a characteristic of a
particular asset or liability. The fair value would, therefore, be HK$94 (calculated as
HK$108 – HK$14, which is the price per unit less transport costs).
Key Learning Point
Under HKFRS 13, fair value represents an exit price and is based on the perspective of
market participants. The market in which an entity normally enters into a transaction
to sell an asset or transfer a liability is presumed to be its principal market or most
advantageous market (if there is no principal market) in the absence of contrary evidence.
The distinction between transaction costs and transport costs is critical. Transaction costs
do not affect the measurement of fair value whereas transport costs do where location is a
characteristic of the asset (e.g. coal).
Knowledge Check Questions
Question 1
Identify whether the following restrictions are taken into account in determining fair value
in accordance with HKFRS 13.
Scenario Y/N
A An equity instrument (financial asset) for which sale is legally restricted for a
specified period and the restriction is embedded in the terms of the instrument
B An equity instrument (financial asset) where an entity has agreed with another
entity not to sell it for at least 12 months
C A loan from a third party (financial liability) where the loan agreement specifies
that assignment or sale of the loan is legally prohibited
D A piece of land that is subject to an enduring legal right of a utility company to run
power cables across the land
Question 2
Identify which one of the following statements is false.
A If there is a quoted price in an active market, an entity must always use that price
unadjusted.
B The requirements in HKFRS 13 need to be applied for all fair value measurements
under HKFRSs.
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Knowledge Check Questions (continued)
C The determination of whether the measurement of fair value takes place on a stand-
alone basis or as a group of assets, liabilities or group of assets and liabilities depends
on the unit of account.
D In determining fair value, HKFRS 13 assumes a hypothetical transaction rather than an
actual transaction at the measurement date.
E If a principal market exists, fair value measurement must always reflect the price in that
market even if the price is more advantageous in another market.
Question 3
Explain the meaning of an orderly transaction in the context of HKFRS 13 and list a few
examples of transactions that are not orderly.
4 . 3 APPLICATION OF FAIR VALUE
4.3.1 Non-financial Assets: Highest and Best Use
When estimating the fair value of a non-financial asset (e.g. property), an entity needs to
account for a market participant’s ability to generate economic benefits by using the asset in its
HKFRS highest and best use (or by selling it to another market participant that would use the asset in
13.27 its highest and best use).
The highest and best use of a non-financial asset takes into account the use of the
asset that is:
• Physically possible, taking into account the physical characteristics of the asset that
market participants would take into account (e.g. it is physically impossible to build a
large production facility on a small block of land);
• Legally permissible, taking into account any legal restrictions that market participants
would take into account (e.g. it is not legally permissible to build a high-rise residential
apartment on land located in an industrial zone); and
• Financially feasible, taking into account whether the use of the asset that is physically
possible and legally permissible generates adequate income or cash flows to produce
HKFRS an investment return that market participants would require (e.g. it is not financially
13.28 feasible to build a large casino in a remote town).
Taking a step back, because HKFRS 13 measures fair value from the perspective of
market participants, an asset’s current use may be irrelevant if market participants would use
HKFRS the asset differently. That said, the highest and best use will usually be the current use
13.29 (but not always).
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The highest and best use of a non-financial asset establishes how the asset’s fair value
should be measured (i.e. the valuation premise), in terms of whether it should be valued:
• On a stand-alone basis; or
HKFRS
13.31 • As a group in combination with other assets or with other assets and liabilities.
Market participants might obtain maximum value from the highest and best use of a
non-financial asset on a stand-alone basis (e.g. land used as a factory site) or through its use in
combination with other assets as a group or in combination with other assets and liabilities
(e.g. a business). In determining whether the asset should be measured on a stand-alone basis
or as part of a group, an entity considers which approach would provide market participants
the maximum value. However, it is important to recognise that HKFRS 13 assumes that sale of a
non-financial asset takes place consistent with its unit of account regardless of the valuation
premise (which is merely a valuation consideration). This is so even when the highest and best
use of an asset is considered to be using the asset in combination with other assets or with
HKFRS other assets and liabilities because a fair value measurement assumes the market participant
13.32 holds those complementary assets and associated liabilities.
Illustrative Example 4
XYZ owns and operates a child-care facility located a few minutes away from Hong
Kong’s Central Business District (CBD). The business comprises a collection of assets
and liabilities, including buildings, furniture and fittings, extensive outside recreational
area, including and adventure playground, land and employee benefit liabilities. XYZ has
elected to apply the revaluation model in HKAS 16 in accounting for its property, plant
and equipment.
At the end of the reporting period, the management of XYZ assess the highest and best
use of the property, plant and equipment from the perspective of market participants. XYZ
management notes that nearby sites have recently been redeveloped for residential use
as high-rise apartment buildings as a result of the booming residential property market in
Hong Kong.
XYZ could continue to use the property, plant and equipment in combination with
other assets and liabilities in providing child-care services to the public. Alternatively,
XYZ could convert the land to residential property. Conversion would involve removing
the current structures on the land. No legal restrictions prevent the change in use
for the site and no physical limitations exist on constructing high-rise residential
apartments.
XYZ determines that the highest and best use of the property, plant and equipment
assets is to convert the land to residential property. The entity needs to consider what a
market participant would do to convert the land, which will involve the cost of obtaining
the necessary permits to enable the change in use of the land and the cost of removing
the buildings and equipment (less the amount realisable from the sale of the assets either
individually or as an asset group).
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Illustrative Example 4 (continued)
Following consultations with valuation experts and real estate specialists, XYZ
estimates the following:
Use as Use as residential
child-care apartments
HK$ HK$
Value 10,000,000 15,000,000
Less: Net cost of removing plant and equipment and — (1,000,000)
obtaining permits
10,000,000 14,000,000
XYZ determines the fair value at HK$14 million because this reflects the highest and
best use from a market participants’ perspective. (Because this use of the assets differs
from the current use, XYZ would disclose that fact as well as the reason why the assets are
being used in a manner that differs from their highest and best use, as the discussed in
Section 4.7.)
The highest and best use principle should be applied in conjunction with the guidance on
the most advantageous market and the valuation premise. All of these concepts will affect the
choice of valuation technique and the valuation assumptions (or inputs).
HKFRS 13 does not require an entity to perform an exhaustive search for other potential
HKFRS uses of a non-financial asset if no evidence suggests the current use of an asset is not its
13.29 highest and best use. For example, XYZ could have assumed the highest and best use of the
property, plant and equipment is its use for providing child-care services had it not become
aware of nearby sites being developed for residential apartments in light of the booming
residential property market.
4.3.2 Application to Liabilities and an Entity’s Own Equity Instruments
Under HKFRS 13, a fair value measurement assumes a liability or an entity’s own equity
instrument is transferred to a market participant at the measurement date.
The transfer assumes that:
• A liability would remain outstanding and the market participant transferee would
be required to fulfil the obligation (i.e. the liability would not be settled with the
counterparty or otherwise extinguished on the measurement date); and
• An entity’s own equity instrument would remain outstanding and the market participant
transferee would take on the rights and responsibilities associated with the instrument
HKFRS (i.e. the instrument would not be cancelled or otherwise extinguished on the
13.34 measurement date).
In practice, observable prices are often unavailable for transfer of instruments with
characteristics identical, or similar to, an entity’s liabilities or own equity instruments, for
example, a decommissioning liability held by an entity. The standard notes that when no
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observable market exists to provide pricing about the transfer of a liability or an entity’s own
equity instrument, an observable market might exist for such items if other parties hold them
as assets (e.g. a corporate bond or a call option on an entity’s shares). When measuring the fair
value of a liability or an entity’s own equity instruments in accordance with HKFRS 13, entities
HKFRS need to maximise the use of observable inputs and minimise the use of unobservable inputs,
13.35–36 as with all fair value measurements.
In circumstances where there is no quoted price for the transfer of an identical or a
similar liability or an entity’s own equity instrument but another party is holding the identical
item as an asset, an entity is required to measure the fair value from the perspective of a
market participant that holds the identical item as an asset at the measurement date. In these
circumstances, the entity measures fair value using the following in, descending order:
1. Use quoted prices in an active market for an identical item held by another party
as an asset;
2. Use other observable inputs (e.g. the quoted price in a market that is not active for the
identical item held by another party as an asset); and
HKFRS
13.37–38 3. Use another valuation technique (e.g. an income approach or a market approach).
Where there is no quoted price for the transfer of an identical or a similar liability or an
entity’s own equity instrument and the identical item is not held by another party as an asset
(e.g. a decommissioning liability), an entity needs to measure the fair value using a valuation
HKFRS technique from the perspective of a market participant that owes the liability or has issued the
13.40 claim on equity. When utilising a present value technique in these circumstances, an entity
might take into account, for example, either of the following:
• The future cash outflows that a market participant would expect to incur in fulfilling the
obligation, including compensation that a market participant would require for the risk
of taking on the obligation; or
HKFRS
• The amount that a market participant would receive to enter into or issue an identical
13.41 liability or equity instrument.
Exhibit 4.5 shows an overview of the process to determine the fair value of liabilities and an
entity’s own equity instruments.
Y Is there an observable market price N
to transfer the instrument?
Fair value = observable market Does somebody hold the
price of instrument corresponding asset?
Y N
Fair value = observable Fair value = fair value Fair value = another
market price of asset Y of the corresponding valuation
(including relevant asset technique***
adjustments)
Is there an observable market
Fair value = another ***Subject to
price for the instrument traded
valuation technique N specific guidance
as an asset?
EXHIBIT 4.5 Determining fair values of liabilities and own equity instruments
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Illustrative Example 5 – Adapted from HKFRS 13 Illustrative Example 12
Debt Obligation: Quoted Price
On 1 January 20X1, Entity B issues at par a HK$2 million BBB-rated exchange-traded
five-year fixed rate debt instrument with an annual 10% coupon. Entity B designated this
financial liability as at fair value through profit or loss for financial reporting purposes.
On 31 December 20X1, the instrument is trading as an asset in an active market
at HK$929 per HK$1,000 of par value after payment of accrued interest. Entity B uses
the quoted price of the asset in an active market as its initial input into the fair value
measurement of its liability (HK$929 × [HK$2 million ÷ HK$1,000] = HK$1.858 million).
In determining whether the quoted price of the asset in an active market represents
the fair value of the liability, Entity B evaluates whether the quoted price of the asset
includes the effect of factors not applicable to the fair value measurement of a liability,
for example, whether the quoted price of the asset includes the effect of a third-party
credit enhancement if that credit enhancement would be separately accounted for from
the perspective of the issuer. Entity B determines that no adjustments are required to
the quoted price of the asset. Accordingly, Entity B concludes the fair value of its debt
instrument on 31 December 20X1 is HK$1.858 million. (Entity B would categorise and
disclose the fair value measurement of its debt instrument within Level 1 of the fair value
hierarchy, as discussed in Sections 4.6 and 4.7.)
Illustrative Example 6 – Adapted from HKFRS 13 Illustrative Example 13
Debt Obligation: Present Value Technique
On 1 January 20X1, Entity C issues at par in a private placement a HK$2 million BBB-rated
five-year fixed rate debt instrument with an annual 10% coupon. Entity C designated this
financial liability as at fair value through profit or loss for financial reporting purposes.
On 31 December 20X1, Entity C still carries a BBB credit rating. Market conditions,
including available interest rates, credit spreads for a BBB-quality credit rating and
liquidity, remain unchanged from the date the debt instrument was issued. However,
Entity C’s credit spread has deteriorated by 50 basis points because of a change in its risk
of non-performance. After accounting for all market conditions, Entity C concludes that if it
was to issue the instrument at the measurement date, the instrument would bear a rate of
interest of 10.5% or Entity C would receive less than par in proceeds from the issue of the
instrument.
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Illustrative Example 6 (continued)
For the purpose of this example, the fair value of Entity C’s liability is calculated using
a present value technique. Entity C concludes that a market participant would use all the
following inputs when estimating the price they would expect to receive to assume Entity
C’s obligation:
A. The terms of the debt instrument, including all the following:
i. Coupon of 10%;
ii. Principal amount of CU2 million; and
iii. Term of four years.
B. The market rate of interest of 10.5%, which includes a change of 50 basis points in
the risk of non-performance from the date of issue.
Application of the present value technique results in Entity C concluding that the fair
value of its liability on 31 December 20X1 is HK$1,968,641.
Entity C does not include any additional input into its present value technique for
risk or profit that a market participant might require for compensation for assuming the
liability. Because Entity C’s obligation is a financial liability, Entity C concludes that the
interest rate already captures the risk or profit that a market participant would require as
compensation for assuming the liability. Furthermore, Entity C does not adjust its present
value technique for the existence of a restriction preventing it from transferring the
liability.
The fair value of a liability should reflect the effect of non-performance risk (including the
entity’s own credit risk) consistent with the unit of account. For example, the issuer of a liability
issued with an inseparable third-party credit enhancement that is accounted for separately
HKFRS
13.42 and from the liability will exclude the effect of the credit enhancement (e.g. a third-party guarantee
13.44 of debt) in the fair value measurement of the liability.
Apply and Analyse 3
Entity B borrows HK$5 million from Bank X at an interest rate of 5%. Entity G (a third party)
has provided a guarantee to Bank X for Entity B’s loan. Entity B estimates that, without this
guarantee, it would be charged an interest rate of 8%.
Determine whether the fair value of the loan liability recognised in Entity B’s financial
statements is based on the actual borrowing rate of 5% (reflecting the third-party
guarantee) or the unguaranteed rate of 8%.
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Apply and Analyse 3 (continued)
Analysis
Entity B should determine if the guarantee is an integral part of the loan or a separate
unit of account. As discussed, the unit of account is not generally addressed by HKFRS 13;
however, the standard does include the following guidance:
. . . the fair value of a liability reflects the effect of non-performance risk on the basis of its unit
of account. The issuer of a liability issued with an inseparable third-party credit enhancement
that is accounted for separately from the liability shall not include the effect of the credit
enhancement (e.g. a third-party guarantee of debt) in the fair value measurement of the
liability. If the credit enhancement is accounted for separately from the liability, the issuer
HKFRS would take into account its own credit standing and not that of the third-party guarantor
13.44 when measuring the fair value of the liability
In this case, there are two separate contracts: the loan between Entity B and Bank X
and the guarantee between Entity G and Bank X. Accordingly, Entity B would not reflect the
guarantee in estimating the fair value of the loan but would use the higher discount rate
(8%) to value the loan liability.
Knowledge Check Questions
Question 4
Entity A owns a large residential investment property in a suburban area. Significant
economic growth has occurred in the area, which has resulted in the construction
of a large shopping complex and a new train station within walking distance to the
investment property. Real estate agents valued the investment property in its current
use at HK$5 million. Various builders have also recently approached Entity A, offering
between HK$8 million and HK$10 million for the property given the potential value
through construction of a high-rise apartment block. Entity A has no intention of selling
the property or building a high-rise apartment in the in the near future as it is currently
undergoing a strategic review of its business model. Identify the highest and best use of
the investment property.
Question 5
Entity C (C) has entered into a three-year loan agreement with Bank B whereby C borrows
HK$10 million at 10% interest per annum. The contract does not permit C to transfer the
liability to another third party. Does C determine the fair value of this liability based on a
settlement value instead of a transfer value?
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4 . 4 FAIR VALUE AT INITIAL RECOGNITION
When an asset is acquired or a liability is assumed in an exchange transaction for that asset or
liability, the transaction price is the price paid to acquire the asset or received to assume the
liability (an entry price). On the other hand, the fair value of the asset or liability is the price that
would be received to sell the asset or paid to transfer the liability (an exit price). Entities do not
HKFRS necessarily sell assets at the prices paid to acquire them. Similarly, entities do not necessarily
13.57 transfer liabilities at the prices received to assume them.
The transaction price may equal the fair value. For example, the transaction price might not
represent fair value if the transaction is between related parties, the transaction takes place
under duress, or the seller is forced to accept the price in the transaction.
If another HKAS or HKFRS requires or permits an entity to measure an asset or liability
initially at fair value and the transaction price differs from fair value, the entity is required to
HKFRS recognise the resulting gain or loss in the profit or loss statement, unless that HKAS or HKFRS
13.60 specifies otherwise.
Illustrative Example 7 – Adapted from HKFRS 13 Illustrative Example 7
Entity A (a retail counterparty) enters into an interest rate swap in a retail market with
Entity B (a dealer) for no initial consideration (i.e. the transaction price is zero). Entity A
can access only the retail market. Entity B can access the retail market (i.e. with retail
counterparties) and the dealer market (i.e. with dealer counterparties).
From the perspective of Entity A, the retail market in which it initially entered into
the swap is the principal market for the swap. If Entity A were to transfer its rights and
obligations under the swap, it would do so with a dealer counterparty in that retail market.
In that case, the transaction price (zero) would represent the fair value of the swap to
Entity A at initial recognition, that is, the price that Entity A would receive to sell or pay to
transfer the swap in a transaction with a dealer counterparty in the retail market (i.e. an
exit price). That price would not be adjusted for any incremental (transaction) costs that
would be charged by that dealer counterparty.
From the perspective of Entity B, the dealer market (not the retail market) is the
principal market for the swap. If Entity B were to transfer its rights and obligations under
the swap, it would do so with a dealer in that market. Because the market in which
Entity B initially entered into the swap differs from the principal market for the swap, the
transaction price (zero) would not necessarily represent the fair value of the swap to Entity
B at initial recognition. If the fair value differs from the transaction price (zero), Entity B
applies HKFRS 9 Financial Instruments to determine whether it recognises that difference as
a gain or loss at initial recognition.
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Knowledge Check Question
Question 6
Identify which of the following statements is correct.
A Fair value of an asset represents the price paid to acquire an asset.
B The transaction price is always equal to fair value.
C At initial recognition, any difference between the transaction price and fair value in
accordance with HKFRS 13 is recognised in profit or loss unless another HKFRS requires
otherwise.
D The price in a related party transaction can never be used as an input for a fair value
measurement.
4 . 5 VALUATION TECHNIQUES
A valuation technique is used to estimate the price at which an orderly transaction to sell an
asset or transfer a liability would take place between market participants at the measurement
date under current market conditions.
HKFRS Broadly, three common types of valuation technique are used; entities should use valuation
13.62 techniques consistent with one or more of them to measure fair value:
1. Market approach;
2. Cost approach; and
3. Income approach.
4.5.1 Market Approach
The market approach generally uses prices and other information generated by market
HKFRS transactions, involving identical or similar assets, liabilities, or groups of assets and liabilities,
13.B5–B7 and the approach incorporates adjustments where necessary.
This approach uses prices that market participants would pay or receive for the transaction
(e.g. quoted market price). In some cases, market prices would need to be adjusted for the
specific asset characteristics. For example, when fair valuing real estate, market prices for
similar properties in the area would be used with adjustments for the specific location and
condition of the property being measured.
Market-based fair value techniques commonly use revenue, EBITDA multiples and matrix
pricing. For instance, when valuing businesses, valuers often utilise EBITDA multiples based on
recent comparable business sales.
Examples of items suitable for fair value measurement using market-based approaches
include quoted shares, traded derivatives and real estate assets.
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4.5.2 Cost Approach
The cost approach generally estimates the cost to acquire or reconstruct a substitute asset of
comparable utility adjusted for obsolescence (often referred to as current replacement cost).
Obsolescence is broader than depreciation and includes physical deterioration, functional
obsolescence and economic obsolescence. The thinking behind this approach is that a market
participant buyer would not pay more for an asset than the amount for which it could replace
the service capacity of that asset. This approach is relevant for non-financial assets and is
generally used for relatively new non-financial assets, highly specialised non-financial assets
HKFRS specialised, or non-financial assets that are valued as part of the valuation of a group of assets
13.B8–B10 or a group of assets and liabilities.
4.5.3 Income Approach
The income approach converts future amounts (e.g. cash flows or income and expenses) to a
single current (i.e. discounted) amount. The fair value measurement reflects current market
HKFRS expectations about those future amounts. Common valuation techniques based on an income
13.B10–B30 approach include present value techniques and option pricing models (Exhibit 4.6)
• Discounted cash flow model
Present value
(e.g. for valuation of a Cash
techniques
Generating Unit)
• Black Scholes Merton and
Option pricing
Binomial models (e.g. for
models
valuation of unlisted derivatives)
Multi period excess • For example, for valuation of
earnings method customer relationships
EXHIBIT 4.6 Valuation techniques to measure
fair value
The selection of a specific present value technique will depend on the facts and
circumstances specific to the asset or liability being measured (e.g. whether prices of
comparable assets or liabilities can be obtained in the market) and the availability of
sufficient data.
Present value techniques generally incorporate the following elements from the
perspective of market participants:
• An estimate of future cash flows for the asset or liability;
• Expectations about possible variability in the amount and timing of cash flows;
• The time value of money (risk free interest rate);
• Market risk premium;
• Other factors that market participants would take into account; and
HKFRS
13.B13 • For a liability, the non-performance risk, including the entity’s own credit risk.
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Illustrative Example 8
Willy Chen Whitegoods (WCW), a manufacturer of whitegoods, has been acquired in a
business combination. WCW provides a three-year warranty to its customers on all of its
whitegoods. Based on WCW’s past experience, warranty claims increase each year of a
contract as the products age.
In accordance with the requirements of HKFRS 3 (Revised) Business Combinations, the
acquirer must measure the warranty liability at its fair value as of the date of acquisition.
Because no observable prices exist for warranty liabilities and the liability has no ‘cost’
(or historical proceeds), the acquirer uses an income approach to estimate the fair value of
the liability. Given the nature of the liability, the acquirer decides to use a present value
valuation technique.
WCW has four distinct product lines: refrigerators; freezers; washing machines; and
dryers. In accordance with the requirements of HKFRS 3 and HKFRS 13, the acquirer
estimates the fair value of expected warranty claims for each product line.
Given the uncertainty relating to the timing and amount of future warranty claims,
the acquirer decides that the expected cash flow technique (also known as expected
value) will provide the best measure of the warranty obligation. Expected value is the
probability-weighted sum of the distribution of possible outcomes and is commonly
known as the arithmetic mean. Accordingly, the acquirer develops expected cash flow
estimates and a probability assessment for various possible outcomes, as illustrated in
the table below in relation to refrigerators. The cash flows are based on assumptions
about the amount and timing of costs expected to be incurred in repairing or replacing the
refrigerators.
Warranty claims – expected cash flows
Refrigerators Probability Year 1 Year 2 Year 3
HK$ HK$ HK$
Outcome 1 60% 3,000 6,000 10,000
Outcome 2 30% 5,000 8,000 15,000
Outcome 3 10% 10,000 18,000 35,000
To estimate the fair value of the warranty liability, the acquirer discounts the
probability-weighted cash flows to their present by applying a discount rate that reflects
the time value of money (the risk free interest rate) and the entity’s non-performance risk.
The acquirer decides that the company’s incremental borrowing rate of 7% is a reasonable
estimate of these factors.
The acquirer also needs to make an adjustment to the probability-weighted cash flows
to reflect the risk that the actual cash outflows may ultimately differ from those expected.
This adjustment, known as the market risk premium, reflects the compensation that
market participants would demand for bearing the uncertainty inherent in the future cash
flows. The adjustment can be factored into the probability-weighted expected cash flows
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Illustrative Example 8 (continued)
or the discount rate but must not be included in both. The acquirer decides to adjust the
discount rate by 3%; based on its subjective judgement of the compensation, a market
participant would demand to assume a liability of this type. This adjustment reduces the
discount rate and has the effect of increasing the amount of the liability.
The following table reflects the expected cash flows and probability weightings from
the previous table and develops an estimate of the fair value of the warranty liability based
on the expected present value of the estimated cash outflows adjusted for risk.
Warranty claims – expected present value of cash outflows adjusted for risk
Refrigerators Year 1 Year 2 Year 3
HK$ HK$ HK$
Outcome 1 1,800 a
3,600 6,000
Outcome 2 1,500 2,400 4,500
Outcome 3 1,000 1,800 3,500
Expected value 4,300 7,800 14,000
Discount rate 4% 4% 4%
Present value factor 0.9615 0.9246 0.8890
Expected present value 4,134 7,212 12,446
Estimated fair value of warranty claims 23,792 b
a
Expected cash outflow in year 1 multiplied by the estimated probability of occurrence of 60%.
b
Sum of the expected present value of warranty claims for years one to three.
The acquirer’s estimate of the fair value of the warranty liability for the refrigerators
assumed in the acquisition of WCW using the income approach to valuation is HK$23,792.
Though present value techniques vary in the extent to which they incorporate the
preceding elements, the following governing principles apply to any present value technique:
• Cash flows and discount rates should reflect assumptions that market participants
would use when pricing the asset or liability;
• Cash flows and discount rates should take into account only the factors attributable to
the asset or liability being measured;
• To avoid double-counting or omitting the effects of risk factors, discount rates should
reflect assumptions that are consistent with those inherent in the cash flows;
• Assumptions about cash flows and discount rates should be internally consistent. For
example, nominal cash flows, which include the effect of inflation, should be discounted
at a rate that includes the effect of inflation; and
HKFRS • Discount rates should be consistent with the underlying economic factors of the
13.B14 currency in which the cash flows are denominated.
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Illustrative Example 9
Entity A acquires Entity B in a business combination. One of the main assets acquired is
Entity B’s brand name, which is well-known in Entity B’s market segment and a key driver
of Entity B’s business.
In determining the fair value of the net identifiable assets acquired in accordance with
HKFRS 3 (Revised) Business Combinations, Entity A will need to measure the fair value of
Entity B’s brand name applying a suitable valuation technique outlined in HKFRS 13.
Given the nature of the asset (brand name) and the manner in which Entity A benefits
from the asset, an income approach would be an appropriate valuation technique in
this case. Considering the lack of comparable assets, a market approach will not be
appropriate. Similarly, given the difficulty in replicating the value of the brand through a
replacement cost calculation, the cost approach is unlikely to be appropriate.
The objective in selecting an appropriate method when applying an income approach
to assets such as brand names, trade names and trademarks is to isolate the net earnings
attributable to the asset being measured. One specialised method commonly used for
such assets is the relief from royalty method. The concept underpinning this method is
that in the absence of ownership rights to the asset, comparable rights to use the asset
can be obtained by way of a licence from a hypothetical third-party owner. The fair value
of the asset is the present value of the hypothetical royalties (licence fees) avoided by
owning the asset (i.e. the royalties saved). Entities need to estimate a royalty rate that best
reflects the nature of the asset being measured.
A single valuation technique is appropriate in some cases (e.g. when valuing assets with
quoted prices in active markets), whereas multiple valuation techniques might be appropriate
in other instances (e.g. when valuing a cash-generating unit).
HKFRS 13 does not specify a hierarchy for valuation techniques nor does it stipulate a
specific valuation technique. Entities need to consider the particular facts and circumstances in
HKFRS choosing the most appropriate valuation technique(s) and should maximise the use of
13.61 observable inputs and should minimise the use of unobservable inputs. For example, when
determining the most appropriate valuation technique(s) for investments in unlisted equity
instruments, an entity will consider, among other things:
• The information reasonably available to the entity;
• The market conditions, for example, a bullish or bearish market might necessitate
different valuation technique(s);
• The investment horizon and type;
• The life cycle of the investee;
• The nature of the investee’s business (e.g. for volatile or cyclical business some
techniques might be better suited than others); and
• The industry in which the investee operates.
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For instance, if there is insufficient information available on expected future cash
flows to apply a discounted cash flow method, using the comparable company valuation
multiples technique may be appropriate, provided that information on comparable company
peers is available. Alternatively, if there is limited financial information for an investee that
pays dividends, an entity could consider using a valuation technique based on dividend
discount models.
Understanding that valuation techniques are estimates of fair value is important. Entities
must be satisfied that the measurement produced by applying the chosen valuation technique
is the best estimate of the price that would be received to sell an asset or transfer a liability in
an orderly transaction between market participants.
Illustrative Example 10
As noted in the opening case, HKPD owns listed shares and unlisted derivatives (options)
among other assets.
In determining the appropriate valuation technique for its listed shares, HKPD
concludes a market-based approach is appropriate, given the availability of quoted prices
in an active market. Unlike the shares, no active market exists for the unlisted derivatives.
Accordingly, in fair valuing its unlisted derivatives, HKPD concludes that the use of an
option pricing model (Black-Scholes-Merton model) would be appropriate. Key inputs
required for this option valuation would include strike price, current share price, time to
expiration of the option, risk free rate and volatility.
4 . 6 INPUTS TO VALUATION TECHNIQUES
The valuation techniques used to measure fair value need to maximise the use of observable
inputs and minimise the use of unobservable inputs. Exhibit 4.7 explains the distinction
between observable and unobservable inputs.
• Inputs that are developed using market data, such as publicly available information
about actual events or transactions, and that reflect the assumptions that market
participants would use when pricing the asset or liability.
Observable • Examples: inputs from stock markets, dealer markets such as over-the-counter
inputs derivatives markets and brokered markets such as real estate markets
• Inputs for which market data are not available and that are developed using the
best information available about the assumptions that market participants would
use when pricing the asset or liability.
Unobservable • Examples: inputs from budgets and forecasted cash flows
inputs
EXHIBIT 4.7 Difference between observable and unobservable inputs
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HKFRS 13 requires an entity to select inputs in applying a valuation technique consistent
HKFRS with the characteristics of the asset or liability that market participants would take into account
13.69 in a transaction to acquire the asset or assume the liability.
4.6.1 Bid and Ask Prices
A bid price is the highest price a potential buyer is willing to pay (for an asset), and an ask price
is the lowest price a potential seller will accept. The difference is the bid-ask spread. In some
markets (e.g. dealer markets), bid and ask prices are quoted. If these prices are used as inputs
to measure fair value, a question arises as to which point in the spread is the best estimate
of fair value. Ostensibly, bid prices should be used for assets and ask prices for liabilities.
However, HKFRS 13 provides more flexible guidance as follows:
• The reporting entity should use the price within the bid-ask spread that is most
representative of fair value;
• The use of bid prices for asset positions and ask prices for liability positions is permitted
but is not required; and
• The use of mid-market pricing or other pricing conventions that are used by market
HKFRS participants is not precluded as a practical expedient for fair value measurements
13.70–71 within a bid-ask spread.
Illustrative Example 11
Entity M has a policy of using a mid-market price when measuring fair value of its
investment in financial assets. The entity has recently become aware that one of its
investments has significant differences between bid prices and ask prices.
Given the bid-ask spread for this investment, Entity M would need to evaluate
whether the mid-market price is representative of its fair value from a market participant’s
perspective and whether any adjustments are necessary to the mid-market price of
the asset.
4.6.2 Premiums and Discounts
HKFRS HKFRS 13 notes that in some cases it may be necessary to make adjustments to inputs to
13.69 valuation techniques, for example, a premium or a discount.
If a quoted price exists in an active market for the asset or liability, then an entity
needs to use that price without adjustment. When no quoted price exists, the fair value
measurement will reflect premiums or discounts if such premiums or discounts will be taken
into consideration by market participants in a transaction for the asset or liability. For example,
when measuring fair value of a controlling interest, a market participant would take into
account a control premium.
On the other hand, when a premium or discount reflects the size of an entity’s holding as
opposed to a characteristic of the holding (e.g. the controlling interest previously noted), the
fair value measurement should not reflect the premium or discount. For example, a blockage
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factor (an adjustment to the quoted price due to the market’s normal daily trading volume
being insufficient to absorb the quantity held by an entity) should not be taken into account
when measuring fair value.
A summary of permitted and prohibited adjustment to inputs are shown in Exhibit 4.8.
Permitted Prohibited
• Adjustments consistent with the unit of • Premiums or discounts reflective of the size of
account an entity’s holdings (blockage factors)
• Adjustments reflective of the characteristics • Adjustments to quoted price in an active market
of the asset or liability
EXHIBIT 4.8 Permitted and prohibited adjustments to inputs
Illustrative Example 12
Stock Holdings Ltd owns 17% of the shares in a company, which is regularly traded
(albeit in small quantities) on the Stock Exchange of Hong Kong (an active market). The
shares are classified under HKFRS 9 as at fair value though profit or loss. Taking quoted
P (price) × Q (quantity) results in a value for the holding of HK$140 million. Management
estimates that to sell such a large block on the Hong Kong stock market would result in a
25% discount to the current price.
A blockage factor would be irrelevant in this example because, consistent with the
requirements of HKFRS 9, the unit of account is a single share. Accordingly, the fair value of
the shareholding is P × Q: HK$140 million.
Illustrative Example 13
Hold Co Ltd owns 15% of the shares in a non-listed entity, comprising 150,000 shares,
classified as at fair value though profit or loss. The quoted price of listed shares of
a comparable company can be used to provide observable market multiples. This
approach results in a fair value for each share of HK$10 in the non-listed entity. However,
the valuation experts advise that:
• A discount of 20% should be deducted to take account of the non-marketability
(illiquidity) of the unquoted shares relative to the quoted shares; and
• To sell such a large block of similar shares would result in a further 10% discount to
the current price.
In this example, the 20% discount for illiquidity is an appropriate adjustment to
the price estimate because it reflects a difference in the characteristics of the ‘similar’
quoted shares and the unquoted shares being valued. The 10% discount for the size of
the holding (blockage factor) is an inappropriate adjustment because the unit of account
is an individual share. In other words, the objective is to achieve a P × Q valuation even
though there is no quoted price for the shares. The fair value is, therefore, HK$1.2 million
(150,000 × HK$10 × 80%).
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4.6.3 Fair Value Hierarchy
To increase consistency and comparability in fair value measurements and related disclosures,
HKFRS 13 establishes a fair value hierarchy that categorises the inputs to valuation techniques
into three levels used to measure fair value (Exhibit 4.9). The fair value hierarchy prioritises the
inputs to the valuation techniques, not the valuation techniques used to measure fair value.
Use this quoted price
Must use without
to measure fair value
adjustment = Level 1
Yes (Level 1)
Is there a quoted
price in an active
market for an identical No use of significant
asset or liability? unobservable inputs =
Level 2
Estimate an exit price
No through a valuation
technique
(Level 2 or 3)
Use of significant
unobservable inputs =
Level 3
EXHIBIT 4.9 Interaction between inputs to valuation techniques and
hierarchy levels
The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active
HKFRS
markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable
13.72 inputs (Level 3 inputs).
Below are the three levels of inputs to the fair value hierarchy outlined in HKFRS 13:
• Level 1: Unadjusted quoted prices in an active market for identical assets or liabilities;
• Level 2: Inputs other than quoted prices in an active market directly or indirectly
observable for the assets or liabilities; and
HKFRS • Level 3: Unobservable inputs for the assets or liabilities.
13.77
HKFRS
Level 1 inputs are the most reliable measure of fair value. Entities need to use Level 1
13.79 inputs without adjustment whenever they are available except in a few limited circumstances.
In some cases, when measuring fair value, an entity may need to use inputs from more
than one level of fair value hierarchy. In such circumstances, the fair value measurement needs
HKFRS
to be classified in its entirety in the same level of the fair value hierarchy as the lowest level
13.75 input that is significant to the entire measurement. This is further explained in the Illustrative
Example in Section 4.6.3.3.
4.6.3.1 Level 1 Inputs
Quoted prices in an active market provide the most reliable evidence of fair value and should
be used without adjustment to measure fair value whenever available. For example, HKPD
would be using quoted prices when fair valuing its investments in listed shares.
For many financial assets and financial liabilities, Level 1 inputs will be available.
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When determining level 1 inputs, an entity needs to consider:
• The principal market (or most advantageous market) for the asset or liability when
there are multiple markets; and
HKFRS • Whether the entity can enter into a transaction for the asset or liability at that price in
13.78 that market at the measurement date.
If an entity holds a position in a single asset or liability (including a position comprising a
large number of identical assets or liabilities, such as a holding of financial instruments) and the
asset or liability is traded in an active market, the fair value needs to be measured within
Level 1 as the product of the quoted price for the individual asset or liability and the quantity
held by the entity. This is the case even if a market’s normal daily trading volume is insufficient
HKFRS to absorb the quantity held and placing orders to sell the position in a single transaction might
13.80 affect the quoted prices.
4.6.3.2 Level 2 Inputs
HKFRS Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable
13.81 for the asset or liability, either directly or indirectly. It is important to recognise that Level 2
inputs need to be observable for substantially the full term of an asset or liability if the asset or
liability has a specified (contractual) term.
Level 2 inputs include the following:
• Quoted price for similar assets or liabilities in active markets;
• Quoted prices for identical assets or liabilities in non-active markets;
• Inputs other than quoted prices that are observable (e.g. interest rates, yield curves,
implied volatilities, credit spreads); and
• Market-corroborated inputs.
HKPD’s investment in unlisted derivative instruments may fall under Level 2 of the fair value
hierarchy if they are based on quoted share prices.
An adjustment to a Level 2 input that is significant to the entire measurement might result
HKFRS in a fair value measurement categorised within Level 3 of the fair value hierarchy if the
13.84 adjustment uses significant unobservable inputs.
4.6.3.3 Level 3 Inputs
HKFRS
13.86 Level 3 inputs are unobservable inputs for the asset or liability. Level 3 addresses fair value
HKFRS measurement in situations where there is little, if any, market activity for the asset or liability at
13.87 the measurement date. HKPD’s investment in unlisted derivative instruments would probably
fall under Level 3 of the fair value hierarchy if the fair value is based on significant unobservable
inputs (e.g. option valuation based on unquoted share prices). Similarly, the fair value of HKPD’s
land assets are likely to be classified as Level 3 if they are based significantly on unobservable
inputs. For example, if the fair value of the land assets is based on the assumption that market
participants would convert them into residential investment properties, any expected rental
returns from the investment properties used in the cash flow forecasts would need to be
adjusted for asset-specific factors, for example, the location and condition of the asset, which
are not observable in the market. If the determination of such adjustments requires significant
judgements or uncertainties, the entire valuation is likely to fall under Level 3 classification.
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When using unobservable inputs to measure fair value, the measurement objective
remains the same; that is, the price at which an asset would be sold or a liability transferred
from the perspective of a market participant that holds the asset or owes the liability.
Accordingly, the unobservable inputs should reflect assumptions market participants would
make in valuing the asset or liability, including assumptions about risk. For example, where
there is significant uncertainty relating to the amount and timing of expected future cash flows,
an entity would need to include a risk adjustment. Assumptions about risk include the risk
inherent in a particular valuation technique used to measure fair value and the risk inherent in
the inputs to the valuation model.
Illustrative Example 14
Example Likely fair value hierarchy
Shares in a listed public company Level 1 as the price is a quoted (unadjusted) price
in an active market for identical assets
Shares in an unlisted private company, Level 3 as the valuation technique (present value)
which are valued using a valuation technique uses significant unobservable inputs
utilising the entity’s own forecasts of expected
future earnings
Listed bonds with infrequent recent Not Level 1 because the most recent price is not
transactions, where the last transaction a price in an active market for the instrument.
was two weeks prior to reporting date. The Level 2 because the inputs are quoted prices for
valuation technique uses the most recent similar items (observable inputs) provided the
quoted price adjusted for observable market adjustments do not use significant unobservable
trends in past two weeks. inputs.
Investment properties are valued using Level 2 or Level 3 (depending on the significance
observable prices per square meter for similar of the adjustments). Likely to be level 2 as the
properties with adjustments for specific inputs are based on observable prices for ‘similar’
characteristics of the properties. properties in an active market. However, if the
adjustment uses significant unobservable inputs,
the entire measurement might result in Level 3.
The inputs used in this valuation do not qualify
as Level 1 inputs as the prices do not represent
quoted prices for ‘identical’ assets in active
markets because though the properties might
be similar in nature, they are not identical due
to factors, such as the exact location, age and
condition of the properties
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Apply and Analyse 4
Enterprise Fund and Large Cap Fund are investment funds that issue units to their
investors. The units issued by these funds are redeemable at the attributable share of the
underlying net assets of the fund.
• Enterprise Fund: Units in this fund are marketed to the public and are issued and
redeemed frequently. A daily price quote is published in the financial press which
represents the average redemption price for the previous day’s transactions. The
underlying investments include quoted shares that would be categorised within
Level 1 and unquoted shares that would be categorised within Level 3 of the fair
value hierarchy.
• Large Cap Fund: This fund is marketed to high net-worth individuals, and units
are issued and redeemed relatively infrequently, typically in large blocks. There
is no published price quote, but the fund manager provides a quarterly valuation
report that includes a unit value. The fund invests only in financial assets quoted in
active markets. The unit value is provided in the quarterly valuation report and is
determined using observable offer prices for the underlying investments, without
significant adjustments.
Explain how the inputs used in fair value measurement of the units in the investment
funds should be classified.
Analysis
Unit in Enterprise Fund = Level 1
The quoted price of a unit in the Enterprise Fund would be a Level 1 input (unadjusted
quoted price in an active market for identical assets). There is frequent buying and
selling of the asset and a quoted price that represents fair value is available. The market
can be considered active in this case even though all the ‘sales’ made by investors are
redemptions with the fund.
Unit in Large Cap Fund = Level 2
The unit valuation provided by the fund manager of the Large Cap Fund would be a Level 2
input. The valuation uses only observable inputs but the market in Large Cap fund units is
not itself active, and the unit valuation does not directly represent actual transaction prices
in the units.
The valuation input for the Large Cap Fund is not considered to be a Level 3 input
because no significant adjustments arise from unobservable inputs in this case.
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Knowledge Check Questions
Question 7
Determine which general family of valuation technique(s) may provide the best approach
for fair value in the following circumstances:
A A cash-generating unit (CGU) comprising a single mine, associated licence and
equipment (HKAS 36)
B A specialised plant and equipment measured using the revaluation model (HKAS 16)
C An interest rate swap (HKFRS 9)
Question 8
Entity Y (Y) has acquired 10,000 shares in Entity Z (Z), which is an unlisted company. Y’s
ownership in Z represents 5% of total shares on issue. Y is able to determine the fair value
of the shares using internal information. Identify the level of fair value hierarchy the inputs
are likely to fall under.
A Level 1
B Level 2
C Level 3
D None of the above because determining a reliable fair value given the unlisted nature of
Z’s shares is impossible
4 . 7 DISCLOSURE
HKFRS 13 contains a comprehensive disclosure framework for fair value measurements. This is
intended to help users of financial statements assess the valuation techniques and inputs used
to develop those measurements.
The extent of disclosures required depends on the classification in the fair value hierarchy
of the inputs used to measure fair value, with increased disclosures applying to the lower levels
of the fair value hierarchy.
The standard makes a distinction between recurring fair value measurements (i.e. fair value
measurements required at each reporting date) and non-recurring measurements (i.e. fair
value measurement triggered only in particular circumstances). The standard also requires
disclosure of the effect of the fair value measurement on profit or loss or other comprehensive
income for the period for recurring fair value measurements that involve significant
unobservable inputs.
HKFRS
13.91–99 Exhibit 4.10 summarises the key disclosure requirements in HKFRS 13.
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Requirement Recurring Non-recurring
Fair value at the end of the period ✓ ✓
Reasons for fair value measurement ✓
Level of fair value hierarchy within which the valuation falls ✓ ✓
(Levels 1, 2 or 3)
Any transfers between different levels of fair value hierarchy ✓
and the reasons for transfer
A description of valuation techniques and inputs used ✓ ✓
(Levels 2 and 3)
Quantitative information about significant unobservable inputs ✓ ✓
used (Level 3)
A reconciliation of changes in fair value measurements (Level 3), ✓
disclosing separately changes during the period attributable to:
• Total gains or losses recognised in profit or loss and the line
item in which they are recognised
• Total gains or losses recognised in other comprehensive
income and the line item in which they are recognised
• Purchases, sales, issues and settlements
• Any transfers into or out of Level 3
A description of valuation process used (Level 3) ✓ ✓
A narrative description of the sensitivity of the fair value ✓
measurement to changes in unobservable inputs if changes in
those inputs (or interrelationships between those inputs) might
result in a significantly higher or lower fair value measurement
(Level 3)
Quantitative effect of changes in unobservable inputs (Level 3) ✓
Reasons where highest and best use of a non-financial asset ✓ ✓
varies from current use
EXHIBIT 4.10 Summary of key disclosure requirements
Illustrative Example 15
The following is an extract from the annual report of Country Garden Holdings Ltd.
Valuation Processes of the Group
The Group’s investment properties were valued at transfer or business acquisition dates,
and at 31 December 2021 and 2020 by Jones Lang LaSalle Corporate Appraisal and
Advisory Limited or Cushman & Wakefield Ltd, independent and professionally qualified
valuers that hold recognised relevant professional qualifications and have recent
experience in the locations and segments of the investment properties valued. For all
investment properties, their current use equates to the highest and best use.
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Illustrative Example 15 (continued)
Discussions of valuation processes and results are held between management
and the valuers on a semiannual basis, in line with the Group’s interim and annual
reporting dates.
At each half year-end, management:
• Verifies all major inputs to the independent valuation report;
• Assesses property valuation movements when compared to the prior year
valuation report; and
• Holds discussions with the independent valuers.
Valuation Techniques
Valuations are based on:
• Direct comparison approach assuming the sale of each of these properties in its
existing state with the benefit of vacant possession. By making reference to sales
transactions as available in the relevant market, comparable properties in close
proximity have been selected and adjustments have been made to account for the
difference in factors such as locations and property size; and/or
• Income capitalisation approach taking into account the current rents of the
property interests and the reversionary potentials of the tenancies, term yield and
reversionary yield are then applied respectively to derive the market value of the
property; or
• Residual method of valuation, which is commonly used in valuing development
sites by establishing the market value of the properties on an ‘as-if’ completed
basis with appropriate deduction of land and construction costs, professional fees,
contingencies, marketing and legal costs, interest payments to be incurred and
anticipated developer’s profits.
There were no changes to the valuation techniques during the year.
Information about fair value measurements using significant unobservable
inputs (Level 3)
Fair value as of Valuation Unobservable Range of
31 December 2021 techniques inputs unobservable
RMB million inputs
Completed 15,037 Income The rate of return/ 2.5%–6.5% per
investment capitalisation capitalisation rate annum
properties
Monthly rental (RMB/ 30–167
square meter/month)
Direct Adjusted market price 1,760–36,000
comparison (RMB/square meter)
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Illustrative Example 15 (continued)
Fair value as of Valuation Unobservable Range of
31 December 2021 techniques inputs unobservable
RMB million inputs
Investment 1,183 Residual Budgeted 640–1,860
properties method construction costs
under to be incurred (RMB/
construction square meter)
Remaining 15%–41%
percentage to
completion
Anticipated 10%–15%
developer’s profit
margin
Fair value as of Valuation Unobservable Range of
31 December 2020 techniques inputs unobservable
RMB million inputs
Completed 14,532 Income The rate of return/ 3%–6% per
investment capitalisation capitalisation rate annum
properties
Monthly rental (RMB/ 46–248
square meter/month)
Direct Adjusted market price 3,700–36,900
comparison (RMB/square meter)
Investment 1,127 Residual Budgeted construction 170–2,100
properties method costs to be incurred
under (RMB/square meter)
construction
Remaining percentage 6%–62%
to completion
Anticipated developer’s 15%–20%
profit margin
Relationships of unobservable inputs to fair value are as follows:
• The higher rate of return/capitalisation rate, the lower fair value;
• The higher monthly rental, the higher fair value;
• The higher market price, the higher fair value;
• The higher budgeted construction cost to be incurred, the lower fair value;
• The higher remaining percentage to completion, the lower fair value; and
• The higher the anticipated developer’s profit margin, the lower fair value.
Source: Adapted from Country Garden Holdings Company Ltd, Annual Report 2021, pages 182–185.
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SUMMARY
• HKFRS 13 outlines the framework to be used when another HKFRS or HKAS requires or
permits the use of fair value for measurement and/or disclosure purposes.
• Fair value 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.
• Fair value represents an ‘exit’ price from a market participant’s perspective based on
a hypothetical transaction at the measurement date in the entity’s principal or most
advantageous market (if there is no principal market).
• Fair value measurement of a non-financial asset takes into account the asset’s highest and
best use from a market participant’s perspective that is physically possible, legally permissible
and financially feasible.
• HKFRS 13 envisages three broadly used valuation techniques: the market approach, the cost
approach and the income approach.
• Entities need to consider the particular facts and circumstances in choosing the most
appropriate valuation technique(s) consistent with the three common approaches set out
in HKFRS 13.
• HKFRS 13 outlines a fair value hierarchy that categories into three levels the inputs to
valuation techniques: Levels 1, 2 and 3. The classification depends on where the input lies in
the spectrum between observable inputs, for example, quoted prices in an active market for
identical assets and unobservable inputs.
• Detailed disclosure requirements appear in HKFRS 13, with a distinction made based on
recurring and non-recurring fair value measurements. The extent of required disclosures is
significant for recurring fair value measurements that involve significant unobservable inputs.
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MIND MAP
SCOPE VALUATION TECHNIQUES
Exclusion of measurement and disclosures Market approach– selling price for similar
• Requirements: items (adjusted as necessary)
- Share-based payments Income approach– present value of future
- Leases income or cash flows
- Measurements similar to fair value such as
Cost approach–cost to acquire or
net realisable value or value in use
reconstruct a substitute asset of
• Exclusion of disclosures: comparable utility
- Employment plan & post-employment plan
assets HIGHEST AND BEST USE
- Recoverable amounts based on fair value Usually current use
less cost to sell
Must be physically possible, legally
FAIR VALUE DEFINITION permissible and financially feasible
The price that would be received to sell an Whether on a stand-alone basis or as a group
asset or paid to transfer a liability in No need for exhaustive search for other
an orderly transaction between market potential uses if no evidence suggests
participants at the measurement date current use is not highest and best use
KEY CONCEPTS/PRINCIPLES FAIR VALUE FAIR VALUE HIERARCHY
MEASUREMENT
Principal market (HKFRS 13) Level 1: Unadjusted quoted price in active
Most advantages market (only used when markets for identical assets or liabilities
no principal market exists) Level 2: Inputs other than quoted prices
Exit price included in Level 1 that are observable
Unit of account (either stand-alone or a group) either directly or indirectly
Level 3: Unobservable inputs
DISCLOSURES
Comprehensive disclosure framework
Extent of disclosure required depends on
the fair value hierarchy applied
Increased disclosures for Level 3 inputs
Distinction between recurring and
non-recurring fair value measurements
Answers to Knowledge Check Questions
Question 1
Scenario Impacts fair value?
Entity holds an equity instrument (financial asset) Yes (restriction is a characteristic of the
for which sale is legally restricted for a specified instrument and would pass on to market
period and restriction is embedded in the terms of participants)
the instrument
Entity holds an equity instrument (financial asset) No (restriction is entity specific and would
and has agreed with another entity not to sell for at not transfer to a market participant)
least 12 months
Entity has a loan from a third party (financial No (restriction is entity specific and would
liability) and the loan agreement specifies that not transfer to a market participant)
assignment or sale of the loan is legally prohibited
Entity holds a piece of land that is subject to an Yes (restriction is a characteristic of
enduring legal right of the utility company to run the asset and would pass on to market
power cables across the land participants)
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Question 2
Answers A, C, D and E are correct.
Answer B is incorrect. The requirements in HKFRS 13 need to be applied for all fair
value measurements under HKFRSs because HKFRS 13 does not apply to ‘all’ fair value
measurements under HKFRSs. For example, the measurement requirements in HKFRS 13 do
not apply to share-based payments (HKFRS 2), leases (HKFRS 16), or measurements that have
similarities to fair value, for example, net realisable value (HKAS 2) or value in use (HKAS 36).
Question 3
An orderly transaction assumes exposure to the market for a period before the
measurement date to allow for marketing activities that are usual and customary for
transactions involving such assets or liabilities. Examples of transactions that are not
orderly include a forced transaction, for example, forced liquidation or distress sale.
Circumstances that may indicate that a transaction is not orderly include the following:
• There was inadequate exposure to the market for a period before the measurement
date to allow for usual and customary marketing activities for transactions involving
such assets or liabilities under current market conditions;
• A usual and customary marketing period existed, but the seller marketed the asset
or liability to a single market participant;
• The seller is in or near bankruptcy or receivership (i.e. the seller is distressed);
• The seller was required to sell to meet regulatory or legal requirements (i.e. the seller
was forced); and
• The transaction price is an outlier when compared with other recent transactions for
the same or a similar asset or liability.
Question 4
Highest and best use is to be determined from market participants’ perspective (rather
than from Entity A’s perspective). Accordingly, the intentions of Entity A do not affect the
assessment of highest and best use. Given the greater potential economic benefit that
market participants would be able to derive by constructing high rise apartments on
the land, the highest and best use is based on the use as high rise apartments (rather
than through its current use), provided the alternative use is physically possible, legally
permissible and financially feasible.
Question 5
No, fair value must be based on transfer value even if Entity C is not permitted to transfer
the liability. This is based on the International Accounting Standards Board’s belief that the
transfer notion ‘captures market participants’ expectations about the liquidity, uncertainty
and other factors associated with the liability whereas the settlement notion may not
because it may incorporate entity-specific factors’.
Question 6
Answer A is incorrect. The price paid to acquire an asset (transaction price) is an entry price
whereas fair value is based on an exit price notion. Exit price is the price that would be
received to sell the asset or paid to transfer the liability.
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Answer B is incorrect. The transaction price will equal the fair value in many cases, but this
may not always the case. For example, the transaction price might not represent fair value
if the transaction is between related parties or the transaction takes place under duress.
Answer C is correct. At initial recognition, in accordance with the requirements in HKFRS
HKFRS 13, any difference between the transaction price and fair value is recognised in the
13.60 statement of profit or loss, unless another HKFRS requires otherwise.
Answer D is incorrect. Related party transactions can still be used as an input for fair value
measurement if there is evidence that the transactions were entered using market terms.
In other words, there is no automatic exclusion for related party transactions.
Question 7
A. An income approach (e.g. a discounted cash flow method) is likely to be the most
appropriate approach to value the cash-generating unit (CGU). Because the CGU is
unique, suitable market information is unlikely to be available to utilise a market
approach. Furthermore, cost is unlikely to be a meaningful measure of fair value in
this case given the nature of the asset; the amount of money spent on the mine does
not necessarily reflect the fair value of the asset.
B. For the specialised plant and equipment, an income approach or a cost approach
would be appropriate. Given the specialised and unique nature of the plant and
equipment, a market approach would be unsuitable.
C. If the interest rate swap is a traded asset, then a market approach could be utilised.
Otherwise the default would be an income approach. The cost approach is better
suited to physical assets or developed assets than derivatives.
Question 8
Answers A and B are incorrect. Levels 1 and Level 2 are not correct as the fair value is not
based on any observable inputs. Furthermore, the requirement to determine fair value is
not affected by the unlisted status of Entity Z. Where no observable inputs are available,
HKFRS 13 requires entities to use unobservable inputs to estimate fair value.
HKFRS Answer C is correct. Entity Y will classify the inputs to the fair value hierarchy as Level 3.
13.86 This is because the inputs are based on internal information.
EXAM PRACTICE
QUESTION 1
Entity X (X) produces widgets that do not have quoted market prices. Refer to the table
below for additional information about X’s markets.
Market A Market B Market C
HK$ HK$ HK$
Total daily sales by sellers of widgets 200,000 100,000 60,000
Trades per month 160 100 80
Price per widget 148 140 150
Transport costs per widget (6) (8) (10)
Transaction costs per widget (10) (6) (4)
Net proceeds per widget 132 126 136
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Required:
(a) Explain how Entity X satisfies the principal or most advantageous market requirements
in HKFRS 13 with respect to widgets. In your response, identify clearly whether its market
is A, B or C.
(b) Calculate the fair value of the widget. Show all workings.
QUESTION 2
FarmCo presently owns a property (land and a barn) with a fair value based on existing
use of HK$12 million. FarmCo allocated HK$10 million to the land, which it presently uses
for cattle grazing and HK$2 million to the barn, which it presently uses as storage for
supplemental cattle feed and hay.
Over the past two years, the land around the farm has been developed into shopping
malls given its strategic location near the middle of three major expressways. The local
council has recently rezoned the area, permitting commercial usage for FarmCo’s land.
Valuation specialists recently valued the land at HK$15 million and estimated the demolition
of the barn would cost HK$300,000. The valuation specialists observed that they did not
identify any physical limitations affecting the development of the land. In addition, they
noted that their valuation took into account recent land sales activity in the surrounding area
as well as the level of rentals currently being charged by property owners.
Explain how the fair value of the land would be determined in accordance with
HKFRS 13, including suitable valuation techniques and the appropriate classification for the
valuation inputs.
ANSWERS TO EXAM PRACTICE
QUESTION 1
(a) The principal market is the market with the greatest volume and level of activity for the
asset or liability being measured. It must be available and accessible to the entity at the
measurement date.
The most advantageous market is the market that maximises the amount received
to sell the asset or minimises the amount paid to transfer the liability after taking into
account transaction costs and transport costs. The most advantageous market is only
selected when no principal market exists.
In this case, the principal market is Market A as it is the market with the greatest
volume and level of activity for the widget. Market C provides the highest value being
$136, which is the most advantageous market.
(b) As a principal market exists (Market A), fair value needs to be determined based on
Market A. Accordingly, the fair value is HK$142 (price of HK$148 less transport costs
of HK$6). Transaction costs are not taken into account as they do not represent a
characteristic of the asset.
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QUESTION 2
The specific asset being measured in this case is the land, which is a non-financial asset.
Accordingly, FarmCo will need to determine the highest and best use of this land from
market participants’ perspective. This involves whether such use is physically possible, legally
permissible and financially feasible.
Based on the information provided, the land can be utilised in its current form as
farmland (in combination with the barn) or it can be developed for commercial use
after demolition of the barn. As the local council has recently rezoned the land allowing
commercial use, such use is legally permissible. Furthermore, the valuation specialists have
advised that commercial use is physically possible. In addition, the valuation of the land by
the valuation experts at an amount higher than the value attributed to the land in its current
use implies that commercial use of the land is financially feasible.
Accordingly, FarmCo would determine the highest and best use of the land by
comparing:
• The value of the land in its present use as farmland (in combination with the barn); and
• The value of the land as a vacant site for commercial use, taking into account the costs
of demolishing the barn and other costs.
The value of the land in its current use is HK$10 million whereas the value of the vacant
land will be HK$14.7 million (HK$15,000,000 − HK$300,000 demolition costs).
Accordingly, the fair value of the land based on its highest and best would be
HK$14.7 million.
An income approach (such as a discounted cash flow method) may be a suitable
valuation technique for valuing the land in its current use. For the commercial use, a market
approach could be used to determine the value of the land (having regard to inputs such as
market prices for similar parcels of land in the area).
Inputs utilised for the income approach are most likely to be unobservable inputs and
therefore Level 3 classification would be appropriate. A market approach would utilise
observable inputs to a large extent (such as prices for similar blocks), and as a result, Level 2
classification may be appropriate unless significant adjustments are made to observable
market inputs in which case Level 3 classification would be appropriate.
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5
Revenue
CHAPTER TOPIC LIST
5.1 Overview 5.4 Other Revenue Recognition
5.1.1 Scope of HKFRS 15 Issues
5.1.2 Terminology 5.4.1 Sale with a Right of Return
5.4.2 Warranties
5.2 Recognition and Measurement:
Five-Step Model 5.4.3 Customer Loyalty Programmes
5.4.4 Consignment Arrangements
5.2.1 Identifying the Contract with a
5.4.5 Bill-and-hold Arrangements
Customer – Step 1
5.4.6 Principal vs Agent Considerations
5.2.2 Identifying the Performance
5.4.7 Licencing
Obligations in the
5.4.8 Repurchase Agreements
Contract – Step 2
5.4.9 Loss-making Contracts
5.2.3 Determining the Transaction
5.4.10 Long-term Construction
Price – Step 3
Contracts
5.2.4 Allocating the Transaction Price
to the Performance Obligations 5.5 Presentation and Disclosure
in the Contract – Step 4 5.5.1 Contracts with Customers
5.2.5 Recognising Revenue When 5.5.2 Significant Judgements in the
(or As) the Entity Satisfies a Application of this Standard
Performance Obligation – Step 5 5.5.3 Assets Recognised from the
5.3 Contract Costs Costs to Obtain or Fulfil a
Contract with a Customer
5.3.1 Costs of Obtaining a Contract
5.3.2 Costs to Fulfil a Contract
5.3.3 Amortisation and Impairment
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LEARNING OUTCOMES
PRINCIPAL LO3: EVALUATE AND ADVISE ON APPROPRIATE ACCOUNTING PRINCIPLES TO
ACCOUNT FOR COMPLEX BUSINESS TRANSACTIONS
LO3.02: A
ccount for, evaluate and advise on business transactions in accordance with Hong Kong
Financial Reporting Standards as they relate to: Revenue
3.02.01 Apply the core principle of recognition of revenue
3.02.02 Apply the criteria for recognising revenue generated from contracts where performance
obligations are satisfied over time
3.02.03 Apply the principle to determine the contract costs to be recognised
3.02.04 Apply the measurement principles as they apply to revenue and related costs
3.02.05 Apply the recognition criteria for specified types of revenue items
3.02.06 Advise the appropriateness of the accounting treatments in respect of the revenue
recognition
3.02.07 Prepare and appraise disclosure in respect of revenue from contracts with customers
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R evenue
OPENING CASE
TELLEV PHONES
T ellev Phones Limited (Tellev) is a telecommunications and technology company, offering a
full range of communications services and competing in all telecommunications markets.
It operates primarily in Hong Kong and mainland China but has in recent years started
extending its international presence by expanding operations into other parts of Asia.
Tellev supplies the retail and corporate market with telephony and digital transformation
solutions, with its most popular retail product being its mobile phone bundle plans (handset,
phone line rental and data). Tellev also sells a range of mobile phone handsets, data plans,
prepaid sim cards and phone-related accessories such as headphones, screen protectors and
cover cases on a stand-alone basis online and in its retail outlets.
In the last year, Tellev introduced a new product: prepaid pocket Wi-Fi devices for rent by
short-term travellers. Under the rental agreement, customers receive a small portable Wi-Fi
router to which customers are able to connect their phones, tablets and laptops to gain access
to a local mobile network. The Wi-Fi router must be returned to Tellev at the end of the rental
period. The market for this product is competitive, and Tellev is aware it is one of the later
entrants to this market. However, Tellev believes its existing brand presence and competitive
pricing will assist it to gain market share in this segment.
Tellev offers a 14-day money back guarantee for change of mind returns on various
of its phone-related accessory products, such as phone cover cases. In addition, although
not required by legislation, Tellev has a long history of replacing or refunding defective
phone-related accessories if the product is returned and determined to be defective within
14 days from purchase. Tellev also acts as a liaison between the phone manufacturer and its
customers for product warranty claims in return for a small fee from the manufacturer.
Tellev’s popular mobile phone bundle plans include a non-cancellable term and penalties
should the customer opt out of the plan early. Under the terms of these plans, the customer
makes a one-time upfront lump sum payment and subsequent monthly payments for the
duration of the agreed plan.
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OVERVIEW
‘Revenue’ is one of those areas of accounting everyone knows about but perhaps few really
understand. The measure of revenue is important as turnover is a headline number for the
reporting, evaluation and forecasting of company performance, and revenue is often included
in company key performance indicators (KPIs) affecting executive remuneration. When making
decisions to buy or sell, investors and potential investors may consider valuation measures,
such as sales multiples or look to sales history and future prospects to understand company
performance. Lenders may make decisions about the riskiness of a loan application having
regard to turnover history.
But how is revenue calculated and when is it recognised in general purpose financial
statements? Consider the case of Tellev, which generates revenue from multiple products and
operates in multiple markets. Does the financial report provide sufficient information for a user
to understand the revenue sources and when revenue amounts are recognised in profit or loss?
This chapter focuses on the recognition of revenue from an entity’s ordinary activities
arising from its contracts with customers. You will gain an understanding of the complexities
in recognising and measuring revenue in general purpose financial statements and of the
treatment of related contract costs. By the end of this chapter, you should also appreciate
the objective and extent of disclosures an entity needs to make about its revenue recognition
policies to help users of its financial statements understand how it has determined its reported
revenue number and its future revenue prospects.
5 . 1 OVERVIEW
This chapter addresses the accounting for revenue from contracts with customers set out in
HKFRS 15 Revenue from Contracts with Customers. HKFRS 15 is a relatively recent accounting
standard that addresses known deficiencies in predecessor Standards on the reporting
of revenue.
The objective of HKFRS 15 is to establish the principles that an entity applies to report
useful information to users of its general purpose financial statements about the nature,
amount, timing and uncertainty of revenue and cash flows arising from its contracts with
customers. HKFRS 15 does this by specifying requirements to promote consistency in revenue
recognition and enhance related disclosures.
In this section, you will gain an understanding of the contracts with customers to which
HKFRS 15 applies and be introduced to some of the terminology relevant to applying the
revenue recognition principles in the HKFRS.
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5.1.1 Scope of HKFRS 15
An entity generates income from a variety of sources, for example, sales of inventory, rental
income, interest on cash holdings, gains on sale of fixed assets and fair value gains on
investment property. HKFRS 15 addresses only income arising from sales of goods and services
that are an output of an entity’s ordinary activities; such income is revenue to the entity.
Revenue from sales of goods and services that are an output of an entity’s ordinary
activities arises from transactions involving contracts with customers. HKFRS 15 applies to all
contracts, or a part of a contract (see Exhibit 5.8), with customers except for:
• Lease contracts within the scope of HKFRS 16 Leases (see Chapter 9);
• Insurance contracts within the scope of HKFRS 17 Insurance Contracts (see Chapter 26);
• Financial instruments and other contractual rights or obligations within the scope of
HKFRS 9 Financial Instruments, HKFRS 10 Consolidated Financial Statements, HKFRS 11
Joint Arrangements, HKAS 27 (2011) Separate Financial Statements and HKAS 28 (2011)
Investments in Associates and Joint Ventures (see Chapter 12 and Chapters 30–34); and
HKFRS • Non-monetary exchanges between entities in the same line of business to facilitate
15.5 sales to customers or potential customers.
Though HKFRS 15 does not apply to rental income from leases, interest income and other
gains and losses on financial instrument contracts or insurance contracts, the corresponding
International Financial Reporting Standards (IFRS) provides the International Accounting
Standards Board (IASB) and similarly, the HKICPA, with a framework for considering revenue
issues relating to those types of contracts with customers.
In addition, the recognition and measurement provisions set out in HKFRS 15 apply when
recognising and measuring gains or losses on disposal of non-financial assets (e.g. assets within
the scope of HKAS 16 Property, Plant and Equipment and HKAS 38 Intangible Assets), even though
such sales are not outputs of an entity’s ordinary activities.
5.1.2 Terminology
Exhibit 5.1 explains some of the language used in HKFRS 15 and in this chapter.
Statement of financial position
Unconditional right to payment for The obligation to refund
goods and services transferred consideration (e.g. cash)
Cash Refund liability
to a customer
The entity’s right to consideration
for goods or services transferred Outstanding obligations
Receivables Contract liability
to a customer when that right is of the entity to transfer
conditioned on something other goods or services to the
than time (e.g. the right to payment Contract assets customer, for which
for transferred Product A is consideration has been
conditional on the delivery Capitalised contract costs received/is receivable
of Product B)
Costs related to obtaining the Statement of profit or loss and other comprehensive income Revenue is recognised
contract or fulfilling the contract when (or as) performance
that qualify for capitalisation obligations are satisfied.
Revenue A performance obligation
is the entity’s contractual
promise to transfer a
product to the customer
Revenue is recognised at the amount of the transaction price.
The transaction price is the amount the entity expects to be
entitled to in exchange for transferring promised goods or
services to a customer, excluding amounts collected on behalf
of third parties
EXHIBIT 5.1 Overview of terms used in HKFRS 15
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Knowledge Check Questions
Question 1
Identify which one of the following is a contract with a customer within the scope of HKFRS 15.
A Company A leases a motor vehicle to Company B.
B Company C writes a put option that is held by Company D.
C Company E, a cleaning operator, provides office cleaning services to Company F.
D Company G and Company H operate in the power industry and supply electricity
to residential homes. Company G agrees to supply electricity now to Company H’s
customers in exchange for electricity being supplied to its customers next month.
Question 2
Identify which one of the following statements is false.
A The accounting for a contract to purchase a business is specified by HKFRS 15.
B An entity applies HKFRS 15 to measure its gain on sale of a head office building.
C The sale of obsolete inventory to a customer is within the scope of HKFRS 15.
D A contract with a customer may be partially accounted for in accordance with HKFRS 15
and partially in accordance with another HKFRS (e.g. HKFRS 9).
5 . 2 RECOGNITION AND MEASUREMENT:
FIVE-STEP MODEL
The core principle of HKFRS 15 is for an entity to ‘recognise revenue to depict the transfer of
HKFRS promised goods or services to customers in an amount that reflects the consideration to which
15.2 the entity expects to be entitled in exchange for those goods or services’.
HKFRS 15 describes a five-step model (see Exhibit 5.2) to assist preparers in recognising and
measuring revenue in accordance with this principle. Under the model, an entity identifies:
• What has been promised to the customer;
• The value it expects to receive in exchange; and
• When the promises will be met.
Identify the Allocate the Recognise revenue
Identify the
performance Determine the transaction price when (or as) the
contract(s) with
obligations transaction price to performance performance
a customer
in the contract obligations obligation is satisfied
What has the entity What value does the entity expect to When is the entity
promised to do receive in exchange entitled to that value
EXHIBIT 5.2 Five-step model to recognising revenue (Source: Based on HKFRS 15, para. IN7.)
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In summary, the model requires revenue to be recognised in profit or loss when (or as)
an entity meets each of its obligations to transfer goods or services under a contract.
(Any consideration received before that time is recognised as a liability, rather than as revenue.)
Though revenue recognition under the model sounds similar to practice before the issue
of HKFRS 15, the HKFRS 15 liability does not represent the concept of ‘unearned income’, but
rather, recognises the outstanding obligation of the entity to transfer resources under the
contract; this is consistent with the description of a liability in the Conceptual Framework for
Financial Reporting (2018) being ‘a present obligation of the entity to transfer an economic
resource as a result of a past event’. Consistently with that liability concept, under the approach
taken in HKFRS 15, an entity measures revenue by reference to ‘pricing the obligation’, rather
than ‘pricing the consideration’.
HKFRS The five-step model must be applied consistently to contracts with similar characteristics
15.3 and in similar circumstances.
Each step in the model will now be explored.
5.2.1 Identifying the Contract with a Customer – Step 1
In Step 1, the entity identifies the contract with a customer to be accounted for in accordance
with HKFRS 15 and whether it combines contracts for the purposes of applying the revenue
recognition and measurement requirements.
5.2.1.1 Identifying the Contract
Revenue is recognised under HKFRS 15 only where it arises in conjunction with a contract
with a customer. Accordingly, Step 1 of the five-step model requires an entity to identify the
customer and the contract.
A contract with a customer encompasses:
• Contract – an agreement between two or more parties that creates enforceable rights
and obligations; and
HKFRS • Customer – a party that has contracted with an entity to obtain goods or services that
15.App A are an output of the entity’s ordinary activities in exchange for consideration.
In many instances, it will be straightforward to determine whether a business arrangement
is a contract with a customer. However, some arrangements are excluded from the accounting
requirements set out in HKFRS 15; for example, where:
• The counterparty to the contract is not a customer because it has contracted to
HKFRS participate in an activity in which the parties share in the risks and benefits that result
15.6 from the activity rather than to obtain the output of the entity’s ordinary activities; and
• A ‘contract’ for the purposes of HKFRS 15 does not yet exist because each party
HKFRS has the unilateral enforceable right to terminate a wholly unperformed contract
15.12 without penalty.
As illustrated in Exhibit 5.3, if the contract is not a contract with a customer, the accounting
for the contract is outside the scope of HKFRS 15, and an entity will need to have regard to
other HKFRS for the accounting. This differs from the accounting implications of contracts
that have yet to qualify to be accounted for under HKFRS 15, but might qualify later. This is
discussed next.
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Contract with a customer exists:
Apply HKFRS 15, except where a scope exception applies
Apply an appropriate other HKFRS
EXHIBIT 5.3 Identifying the applicable HKFRS
Illustrative Example 1
Investiga Limited (Investiga), a biotechnology company, enters into an arrangement
with Pharma Limited (Pharma), a pharmaceutical company focusing on cardiovascular
drugs, to collaborate to develop and test a new beta blocker that either company
can commercially exploit. Investiga concludes that Pharma is not a customer in
this arrangement because the parties have agreed to participate in research and
development activity in which they share in the risks and benefits that result from the
activity rather than to obtain the output of Investiga’s ordinary activities (e.g. a new drug).
Consequently, Investiga determines that this is not a contract with a customer and that it
should have regard to another HKFRS (e.g. HKFRS 11 Joint Arrangements).
Pharma also engages Investiga to perform testing on the comparative medical
performance of a new beta blocker against another product currently on market
as Pharma wants to know whether it should stop selling the other product. In this
arrangement, Investiga concludes that Pharma is a customer because Pharma has
contracted with Investiga to obtain the results of its research services (forming part of
Investiga’s ordinary activities) in exchange for consideration. Consequently, Investiga
determines that this arrangement is a contract with a customer and, accordingly, HKFRS 15
applies to the arrangement.
Once an entity has determined that a contract with a customer exists, the entity then
considers whether the contract presently meets the criteria for accounting for the contract in
accordance with HKFRS 15. An entity applies the revenue recognition principles in the HKFRS
(i.e. it proceeds to Step 2) only to contracts with customers that demonstrate all of the features
as depicted in Exhibit 5.4:
Account for contract only when:
Approved by all parties
Rights to goods/services are identifiable
Payment terms are identifiable
Contract has commercial substance
It is probable consideration will be collectible
EXHIBIT 5.4 Criteria for accounting for a
contract under HKFRS 15
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An entity does not apply the revenue recognition principles in HKFRS 15 if, at contract
inception, the entity determines it is unlikely to receive the agreed compensation for goods
HKFRS transferred, meaning it must be probable that the customer is able to, and intends to pay,
15.9 the amount agreed in the contract.
HKFRS A contract need not be approved in writing to create enforceable rights and obligations;
15.9 approval can be given orally or in accordance with other customary business practices. For
example, when Tellev sells a headphone, the contract is approved when the purchase is logged
at a checkout counter and payment is made, there is no paper ‘contract’ signed by both parties
nor necessarily a verbal transaction. Contrastingly, a contract between Tellev and a new
corporate client to provide IP telephony services for the next three years is likely to be
HKFRS approved in writing. All parties must be committed to performing their respective obligations
15.9 under the contract for the contract to be regarded as approved.
As mentioned earlier in this section, a ‘contract’ for the purposes of HKFRS 15 does not yet
exist if there is no contract to recognise when each party to the contract has the unilateral
HKFRS enforceable right to terminate a wholly unperformed contract without compensating the other
15.12 party. For example, Tellev would not record a journal entry on signing up a customer to a
phone plan until the start date of that plan if the customer has not yet made a payment, and
the contract can be cancelled before the start date without penalty. A contract has commercial
HKFRS substance when the risk, timing or amount of the entity’s future cash flows is expected to
15.9 change as a result of the contract.
Once the entity has determined that the features previously described are met, it does
not need to reassess the criteria against remaining rights and obligations under the
HKFRS contract unless there is an indication of a significant change in facts and circumstances,
15.13 including the customer’s ability to transfer remaining consideration due under the contract.
HKFRS Such a change may indicate that the remaining contractual rights and obligations are no
15.BC34 longer enforceable.
HKFRS Where the criteria, summarised in Exhibit 5.4, are not met at contract inception, an entity
15.14 continues to assess the contract to determine whether they are subsequently met. Until such
time, HKFRS 15 requires a liability to be recognised for any consideration received from the
customer, measured at the amount of the consideration received. The liability represents either
the obligation to refund the monies to the customer or the obligation to transfer goods or
HKFRS services to the customer in the future (a deposit liability); the nature of the liability is dependent
15.16 on the facts and circumstances of the transaction.
Where the features previously described are met neither at contract inception nor
subsequently, the entity recognises revenue only when:
• The entity either has no remaining obligations to transfer goods or services to the
customer and all (or substantially all) the consideration received on the contract is
non-refundable (i.e. the contract is completed); or
HKFRS
15.15 • The contract has been terminated and any monies received are non-refundable.
Exhibit 5.5 summarises the accounting for a contract with a customer that does not meet
the initial recognition criteria at contract inception.
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YES Timing of revenue recognition
At contract inception Recognition criteria met
specified by the model (Go to Step 2)
NO
Recognise a refund liability
or deposit liability for any
Reassess during consideration received
duration of contract
Contract completed or YES Consideration YES
terminated without received is non- Recognise revenue
recognition criteria being met refundable
EXHIBIT 5.5 Timing of revenue recognition when initial recognition criteria is not met at
contract inception
Apply and Analyse 1
Appaloosa is a small toy manufacturer producing ‘Pony Posse’, last year’s best-selling
toy. Morgan Limited (Morgan), a construction company, signs a contract with Appaloosa
Limited (Appaloosa) to build a warehouse to hold Appaloosa’s products for HK$1.3 million.
The new warehouse is part of Appaloosa’s plan to significantly expand its operations, but
as it will need to generate sales from a new product line to finance the warehouse build,
Appaloosa has negotiated for periodic payments to occur at a later time compared with
Morgan’s normal payment schedule. Under the terms of the contract, Appaloosa will make
a non-refundable upfront payment of HK$200,000.
Does Morgan have a contract with a customer to account for in accordance with
HKFRS 15?
Analysis
Morgan determines that the contract with Appaloosa is a contract with a customer because
the agreement is for Morgan to build (Morgan’s ordinary activity) a warehouse (the output
of Morgan’s construction services) in exchange for consideration. Morgan identifies the
contract as being none of a lease, an insurance contract, a financial instrument or a
contractual right or obligation relating to its investment in a subsidiary, associate or joint
venture. Accordingly, Morgan concludes it has a contract with a customer within the scope
of HKFRS 15.
Next, Morgan assesses whether all the criteria for accounting for the contract in
accordance with HKFRS 15 are presently met. Morgan determines:
• The contract has been approved by both parties – the contract is signed by both
parties and an assessment of the facts and circumstances indicate that both parties
are committed to their obligations as (1) the work forms part of Morgan’s revenue-
generating operations and (2) Morgan analyses that Appaloosa is committed to
the contract as Appaloosa has made more than a nominal deposit payment and
has sought contract terms that suggest it intends to pay the remainder of the
contracted consideration;
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Apply and Analyse 1 (continued)
• The right to a good is identifiable – the right to the built warehouse is promised in
the contract;
• The payment terms are identifiable – the consideration for the warehouse and the
payment schedule are stated in the contract; and
• The contract has commercial substance – Morgan’s cash flows are expected
to change as a result of the contract as it will be compensated for building the
warehouse.
However, Morgan observes that Appaloosa’s ability and intention to pay for the
warehouse build are in doubt because Appaloosa does not currently have any reliable
income source other than ‘Pony Posse’, and it is aware that the popularity of toys can be
short-lived. Morgan also observed that Appaloosa may not be expecting an immediate
up-tick in demand for any new product or additional inventory of Pony Posse as it has
sought delayed payment terms.
On balance, after considering the terms of the contract and the other relevant facts
and circumstances, Morgan concludes that it is not probable that Morgan will collect the
HK$1.3 million it is entitled to in exchange for the transfer of the warehouse. Accordingly,
Morgan determines that not all the criteria for accounting for the contract in accordance
with HKFRS 15 are met at contract inception. Morgan consequently concludes that it does
not, at contract inception, have a contract with a customer to account for in accordance
with HKFRS 15.
Until Morgan changes its expectations about the probability of collecting from
Appaloosa the consideration to which it is entitled (HK$1.3 million) or the contract is
completed or terminated, Morgan makes the following journal entry for the amount of the
upfront payment:
Debit Credit
HK$ HK$
Cash 200,000
Deposit liability 200,000
5.2.1.2 Combination of Contracts
HKFRS As illustrated in Exhibit 5.6, each contract with a customer is a unit of account for the purposes
15.BC72 of recognition and measurement in accordance with HKFRS 15. However, in certain
circumstances, separate contracts must be combined and accounted for as though the bundle
were a single contract. In these instances, the unit of account is the group of contracts because
combining the contracts more faithfully represents the substance of the resulting economic
phenomena. Identification of the unit of account is important because the amount and timing
HKFRS of revenue might differ depending on whether an entity accounts for two or more contracts
15.BC71 separately or as a single contract.
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Possible units of account
A single contract A combined contract A portfolio of similar contracts
(as though it were a single contract)
EXHIBIT 5.6 Identifying the contract that is the unit of account
HKFRS 15 requires an entity to account for two or more contracts entered into at or
near the same time with the same customer (or related parties of the customer) as a single
combined contract if at least one of the following criteria is met:
• The contracts are negotiated as a package with a single commercial objective.
• The consideration to be paid in one contract depends on the price or performance of
the other contract.
• The goods or services promised in the contracts (or some goods or services promised in
each of the contracts) are a single performance obligation (see Section 5.2.2).
For example, a developer selling a house-and-land package (a package with a single
commercial objective) to a customer may be required legally to effect the sale of the land
separately from the sale of the building (i.e. in two contracts).
Key Learning Point
An entity needs to understand what it has contracted to sell before analysing the timing
and amount of revenue recognition under the contract(s).
In addition, as a practical expedient, an entity may apply the accounting set out in HKFRS 15
to a portfolio of contracts with similar characteristics if the entity reasonably expects that the
effects on the financial statements of applying the requirements of HKFRS 15 to the portfolio
HKFRS would not differ materially from those if the Standard were applied on a contract-by-contract
15.4 basis. Of course, when accounting for a portfolio, an entity will need to use estimates and
assumptions that reflect the size and composition of the portfolio. For example, if Tellev were
to account for each sale of headphones on a contract-by-contract basis, it would assess
whether the headphones would be returned based on that single sale transaction (i.e. 100%
returned or 100% retained by the customer). However, if Tellev were to apply the requirements
of HKFRS 15 to a portfolio comprising multiple sales of headphones, it would determine the
probability of headphones being returned based on the size of the portfolio, e.g. it may
estimate that two out of every 50 headphones sold will be returned.
5.2.1.3 Contract Modifications
A contract modification is a change in the scope or price (or both) of a contract that is approved
by the parties to the contract. Depending on the terms of the modified contract, a contract
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HKFRS modification may be accounted for as an adjustment to the existing contract or as a separate
15.20–21 contract. Exhibit 5.7 explains the accounting to be applied to a contract modification.
Contract modification
is approved +
Contract scope increases due to
NO additions of distinct goods/services(1)
YES
Price increase reflects stand-alone
selling price(2) for the additional Treat contract modification as a
goods/services + allowance for separate contract to the original
YES
circumstances (e.g. discount)
+
NO
Remaining goods/services under the Treat contract modification as a
modified contract are distinct(1) from termination of the existing contract and
those already transferred YES the creation of a new contract. +
NO
PARTLY
Treat contract
modification as an Treat contract modification partly as an
adjustment to the adjustment to the existing contract and
existing contract partly as the creation of a new contract
+ + +
+ +
(1) Goods and services are distinct when the good/service can be independently transferred to the customer (rather
than in combination with other goods/services) and a customer can benefit from it. Distinct goods and services
are discussed further in Section 5.2.2.2.
(2) Stand-alone selling price is the price at which an entity would sell a promised good or service separately to a
customer. Stand-alone selling prices are discussed further in Section 5.2.4.1.
EXHIBIT 5.7 Accounting for a contract modification
When the contract modification is treated as a termination of the existing contract and the
creation of a new contract, the amount of consideration allocated to the new contract is the
sum of the revenue not yet recognised on the existing contract plus the amount of additional
consideration promised under the modification. Revenue recognised to date is not adjusted;
however, as the terms of the agreement have now changed, the amounts or timing of future
revenues on transfer of goods or services could change.
In contrast, when the contract modification is treated as an adjustment of the existing
contract, the entity recognises an adjustment to revenue to account as though the modification
HKFRS had always been present: to reflect the effect of the modification on the transaction price and
15.21 entity’s progress towards satisfaction of its obligations under the contract.
When the contract modification is treated as a separate contract, the accounting for
the existing contract is not affected by the modification. Accordingly, in those instances, the
modification affects neither the timing nor amount of revenue recognised to date on the
existing contract nor the portion not yet recognised.
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Illustrative Example 2
Tellev enters into a contract with customer Lai to provide Lai with mobile phone services
under its ‘Best Value HK Service Plan’. Under the plan terms, Lai pays a monthly fee of
HK$250 in exchange for access to 6GB of data usage, 10,000 local SMSs and 4,000 local
call minutes. The contract continues until customer Lai decides to opt out of the plan.
Lai has been on the phone plan for three years when Tellev advises Lai that it is
modifying the plan benefits to remain market competitive. Under the modified terms,
Tellev offers Lai future access to 8GB of data usage, 10,000 local SMS and unlimited local
call minutes for the same price. Lai accepts the contract modification implicitly by not
opting out of the plan.
Tellev assesses that:
• The scope of the contract has increased by distinct goods and services (additional
data and call time); and
• The goods and services to be supplied under the modified contract are completely
distinct from those transferred before the date the modification takes effect
because none of the future plan payments by Lai relate to previously consumed
services (as access to 6GB of data usage, 10,000 local SMSs and 4,000 local call
minutes in previous months has been consumed).
Accordingly, following the decision tree, Tellev determines that the modification should
be accounted for as the termination of the existing contract and the creation of a new
contract. Therefore, Tellev does not adjust revenue recognised to date as a result of the
modification. The impact of the modification is reflected in Tellev’s financial statements on
a prospective basis.
(Note: You will learn how to identify distinct goods and services in Section 5.2.2.2 and
in later examples and exercises in this chapter.)
5.2.2 Identifying the Performance Obligations in the Contract – Step 2
At contract inception, having identified that a contract with a customer exists and presently
qualifies for accounting under HKFRS 15, the next step is for the entity to identify its promises
to provide goods and services to the customer under the contract; HKFRS 15 refers to these
as ‘performance obligations’. The process of identifying performance obligations is sometimes
referred to as ‘unbundling’.
A performance obligation is defined in HKFRS 15 as a promise in a contract with a
customer to transfer to the customer either:
• A good or service (or a bundle of goods or services) that is distinct; or
HKFRS • A series of distinct goods or services that are substantially the same and that have the
15.App A same pattern of transfer to the customer.
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Key Learning Point
An obligation in a contract that does not involve the transfer of goods or services to the
customer is not a performance obligation.
For example, when Tellev sells a mobile phone plan comprising a handset plus two years of
unlimited call minutes to customer Peng, the distinct products in the contract are the mobile
phone handset and the call minutes. The performance obligations in the contract are the
promise to transfer the mobile phone handset and the separate promise to transfer access to
airtime. Although Tellev will need to perform various administrative activities to set up the
contract with Peng to enable the contract to be fulfilled (e.g. creating a customer record), such
HKFRS activities are not performance obligations because those activities do not directly transfer a
15.25 service to Peng.
As illustrated in Tellev’s contract with Peng, a contract may include one or more
performance obligations. Appropriate identification of the distinct performance obligations in a
contract is important as HKFRS 15’s principles require revenue to be recognised on satisfaction
of a performance obligation. Accordingly, if distinct performance obligations, i.e. the units of
HKFRS account, are wrongly identified, this could affect the timing or amount of revenue recognition
15.BC85 such that revenue is not recognised on a basis that faithfully depicts the entity’s performance.
For example, if an entity has contracted to construct and transfer a finished building to its
customer, inappropriately identifying the stages of construction as the performance obligations
(rather than the finished building) in the contract could result in the premature recognition of
revenue over the duration of the contract at amounts inconsistent with the requirements of
the HKFRS.
As a practical expedient, HKFRS 15 permits an entity to apply its accounting requirements
to a portfolio of performance obligations with similar characteristics if the entity reasonably
expects that the effects on the financial statements would not differ materially from those
HKFRS determined had the Standard been applied on a performance obligation-by-performance
15.4 obligation basis.
5.2.2.1 Promises in Contracts with Customers
Promises in contracts with customers may be:
• explicit – identified goods or services; or
• implicit – promises implied by customary business practices, published policies or
HKFRS 15.24, specific statements if those promises create a valid expectation of the customer that
15.BC84 the entity will transfer a good or service to the customer. These promises need not be
legally enforceable to create a valid expectation. An example of an implicit promise to
HKFRS transfer a good to a customer is a promise to provide ‘when-and-if-available’ software
15.BC87 upgrades on purchased software packages.
Certain goods or services to be transferred in a contract may be explicitly identified but
considered by some entities to be marketing incentives or incidental to the transaction.
For example, Tellev may provide a ‘free’ mobile phone handset when customers sign up to a
two-year mobile phone service plan. Other examples of performance obligations could include
‘anytime free’ spectacle frame adjustment services or top-ups of lens cleaning solutions, annual
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‘free’ maintenance provided by automotive manufacturers and customer loyalty points
awarded by airlines and credit card companies. HKFRS 15 adopts a view that all distinct goods
and services that a customer receives are performance obligations of the contract even though
HKFRS the entity’s assessment from the perspective of its business model of the main goods or
15.BC88–89 services supplied under the contract could differ.
Key Learning Point
Though the concept of a performance obligation is similar to the notions of deliverables,
components or elements of a contract in previous HKFRSs addressing revenue recognition,
the ‘performance obligations’ in a contract may not be obvious.
5.2.2.2 Distinct Goods or Services
Each distinct promised good or service is usually a separate performance obligation. A good
or service that is not distinct is combined with other goods and services until a distinct bundle
of goods or services is identifiable; the distinct promised bundle of goods or services is
identified as a separate performance obligation. An entity may conclude that a contract
HKFRS contains a single performance obligation representing the bundle of all the promised goods
15.30 and services.
A good or service (or bundle of goods or services) is distinct when:
• The customer can benefit from the good or service either on its own or together with
other resources readily available to the customer, that is, the good or service could be
used, consumed, sold for an amount that is greater than scrap value or held in a way
that generates economic benefits. That a good or service is regularly sold separately
would typically indicate a customer can benefit from that good or service on its own or
together with other readily available resources; and
• The entity’s promise to transfer the good or service to the customer is separately
HKFRS identifiable from other promises in the contract (i.e. the good or service is distinct within
15.27–28 the context of the contract).
To determine whether an entity’s promises to transfer goods or services to the customer
are separately identifiable from other promises in the contract, an entity considers whether it
has promised to transfer a good or service individually or has promised to transfer a combined
item or items to which the promised goods or services are inputs. Indicators that goods or
services are not separately identifiable include:
• The entity provides a significant service of integrating the goods or services with other
goods or services promised in the contract into a bundle of goods or services that
represent the combined output or outputs for which the customer has contracted;
• One or more of the goods or services significantly modifies or customises, or are
significantly modified or customised by, one or more of the other goods or services
promised in the contract; and
HKFRS
15.29 • The goods or services are highly interdependent or highly interrelated.
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Series of Distinct Goods or Services
HKFRS To simplify the application of the five-step approach and to promote consistency in
15.BC113 identification of performance obligations, HKFRS 15 also identifies as a (single) performance
obligation the promises in a contract to transfer to a customer a series of distinct goods or
HKFRS services that are substantially the same and that have the same pattern of transfer to the
15.22 customer. An example is a cleaning service contract where the entity provides the same service
(cleaning) consecutively over a period of time.
A series of distinct goods or services has the same pattern of transfer to the
customer when:
• Each distinct good or service in the series that the entity promises to transfer
to the customer would otherwise qualify as a performance obligation satisfied
over time (whether a performance obligation is satisfied over time is discussed in
Section 5.2.2); and
• The same method would be used to measure the entity’s progress towards complete
HKFRS satisfaction of the performance obligation to transfer each distinct good or service in
15.23 the series to the customer.
Apply and Analyse 2 – Adapted from HKFRS 15 Illustrative Examples,
Example 11
Maize Limited (Maize) enters into a contract with customer Corn Limited (Corn) to transfer
a software licence, perform an installation service and provide software updates for a
three-year period. Maize sells each service separately.
As part of the installation, Maize agrees to substantially customise the software to add
significant new functionality to enable the software to interface with other customised
software applications used by Corn. The installation service, including the customisation,
can be performed by other entities. The software remains functional without any
future updates.
Determine the distinct performance obligations in this contract.
Analysis
Maize has two distinct performance obligations in this contract, being its:
• Promise to transfer customised software (comprising the software licence and
installation service); and
• Promise to provide software updates.
This is because although Corn can benefit from each of the promises to transfer a
software licence, install the software, and provide software updates on its own by using
or reselling the above listed items for an amount greater than scrap value or benefiting
from it together with other readily available resources, Maize’s promise to provide the
installation service is not distinct from its promise to transfer a software licence.
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Apply and Analyse 2 (continued)
This is because, in this instance:
• Maize will be providing a significant service of integrating the licenced software
into the existing software system by performing a customised installation service
(i.e. the licence and the installation are inputs to produce a functional and
integrated software system as an output); and
• The installation service significantly modifies the software because the service will
add significant new Corn-specific functionality to the software.
Maize’s promise to provide software updates is a promise to transfer a distinct good
because this software service is sold separately and the software remains functional
without the updates (i.e. the software updates are separately identifiable from the other
promised products).
5.2.3 Determining the Transaction Price – Step 3
In this Step, the entity identifies the total amount of revenue it will eventually recognise.
Revenue is measured at the transaction price of the contract. The transaction price of a
contract is the ‘amount of consideration to which an entity expects to be entitled in exchange for
HKFRS transferring promised goods or services to a customer, excluding amounts collected on behalf
15.App A of third parties’. That is, under the HKFRS 15, revenue recognition model, the total revenue
recognised for products transferred in a contract may not be equal to the fair value of the
consideration received.
HKFRS HKFRS 15 requires an entity to have regard to the contract terms and the entity’s customary
15.47 business practices in determining the transaction price of a contract. The transaction price is
determined at contract inception, and re-estimated (where appropriate) at the end of each
reporting period for changes in value.
The nature, timing and amount of consideration promised by a customer will affect an
entity’s estimate of the transaction price (however, the entity’s expectations of a customer’s
credit riskiness does not). The consideration promised in a contract may be for a fixed
amount (e.g. retail price), a variable amount (e.g. retail price less a bulk purchase discount) or
HKFRS be a combination of fixed and variable amounts (e.g. base fee plus an on-time
15.48 performance bonus).
An entity’s estimate of the transaction price of a contract includes the effects of:
• Variable consideration, including constraining estimates of variable consideration;
• The existence of a significant financing component in the contract;
• Non-cash consideration; and
HKFRS
15.48 • Consideration payable to a customer.
The effect of each of these factors on the transaction price will now be discussed.
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5.2.3.1 Variable Consideration
The consideration promised in a contract with a customer can vary because of discounts,
rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties or
other similar items. ‘Variable consideration’ refers to any amount variable under the contract.
For example, the promised consideration in a contract to sell to a customer pens for a price
that varies between HK$90 and HK$100 per unit depending on the quantum purchased by the
customer over the course of a calendar year is variable consideration.
HKFRS The variability of consideration may be contingent on the occurrence or non-occurrence of
15.51 a future event. A sale with a right of return is an example of variable consideration where the
variability is contingent on a customer’s future actions.
Though variability relating to the promised consideration will normally be explicitly stated
in a contract, HKFRS 15 identifies the following circumstances as also giving rise to variable
consideration:
• The customer has a valid expectation arising from an entity’s customary business
practices, published policies or specific statements that the entity will accept an amount
of consideration that is less than the price stated in the contract, that is, it is expected
that the entity will offer a price concession.
HKFRS • Other facts and circumstances indicate that the entity’s intention, when entering into
15.52 the contract with the customer, is to offer a price concession to the customer.
Expected Value Approach vs Most Likely Amount Approach
For the purposes of determining the transaction price of a contract, an entity will need to
estimate the amount of any variable consideration to which it expects to be entitled. The entity
estimates this amount of variable consideration using either the:
• Expected value method – the sum of probability-weighted amounts in a range of
possible consideration amounts. An expected value may be an appropriate estimate of
the amount of variable consideration if an entity has a large number of contracts with
similar characteristics; or
• Most likely amount method – the single most likely amount in a range of possible
consideration amounts. The most likely amount may be an appropriate estimate
HKFRS of the amount of variable consideration if the contract has only two possible
15.53 outcomes.
The entity must:
• Use the method that it expects to better predict the amount of variable consideration
to which it will be entitled;
• Apply the same method consistently throughout the contract duration when estimating
the effect of an uncertainty on an amount of variable consideration to which it will be
entitled; and
• Consider all the information (historical, current and forecast) that is reasonably
HKFRS available to it and identify a reasonable number of possible consideration
15.53–54 amounts.
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Illustrative Example 3 – Adapted from HKFRS 15 Illustrative Examples,
Example 21
Granite Limited (Granite) enters into a contract with customer Marble Limited (Marble)
to construct an office building. The promised consideration is HK$12 million, but that
amount will be reduced or increased depending on the timing of completion of the asset.
Specifically, for each day after 30 June 20X1 that the building is incomplete, the promised
consideration is reduced by HK$50,000. For each day before 30 June 20X1 that the
building is complete, the promised consideration increases by HK$50,000. In addition, if
the building receives a certificate of occupancy without rework needed to the property,
Granite will be entitled to an incentive bonus of HK$1 million.
Granite determines there is a:
• 65% probability the building receives a certificate of occupancy without rework;
• 25% probability the building will be completed three days before 30 June 20X1;
• 20% probability the building will be completed two days before 30 June 20X1;
• 50% probability the building will be completed four days after 30 June 20X1; and
• 5% probability the building will be completed five days after 30 June 20X1.
In determining the transaction price, Granite prepares a separate estimate for each
element of variable consideration to which it will be entitled:
• Granite uses the ‘expected value’ method to estimate the variable consideration
associated with the daily penalty or incentive. This is because it expects this
method to better predict the amount of consideration to which it will be entitled.
Granite determines the variable consideration for this element to be:
Possible consideration Probability Consideration entitled to
of outcome
HK$12,150,000 25% HK$12,150,000 25% = HK$3,037,500
HK$12,100,000 20% HK$12,100,000 20% = HK$2,420,000
HK$11,800,000 50% HK$11,800,000 50% = HK$5,900,000
HK$11,750,000 5% HK$11,750,000 5% = HK$587,500
Estimated variable consideration HK$11,945,000
• Granite uses the ‘most likely amount’ method to estimate the variable
consideration associated with the incentive bonus because only two possible
outcomes are possible (HK$1 million or HK$0), and it is the method that Granite
expects to better predict the amount of consideration to which it will be entitled.
As Granite estimates there is a 65% probability the building receives a certificate of
occupancy without rework, it determines the variable consideration relating to this
element to be HK$1 million.
Consequently, Granite estimates the transaction price of the contract to be HK$12,945,000.
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Constraining Estimates of Variable Consideration
However, a constraint applies to the estimate of the amount of variable consideration to which
an entity expects to be entitled. An entity includes variable consideration in its estimate of
transaction price only to the extent it is:
HKFRS highly probable that a significant reversal in the amount of cumulative revenue recognised will not
15.56 occur when the uncertainty associated with the variable consideration is subsequently resolved.
This is consistent with the principle that revenue reflects, with a high degree of confidence,
the consideration the entity expects to be entitled to in exchange for products. However, an
exception to this rule applies for sales-based or usage-based royalties promised in exchange
for a licence of intellectual property; the exception is discussed in Section 5.4.7.2.
An entity considers the likelihood and the magnitude of the potential revenue reversal
when assessing whether it is highly probable that a significant reversal in the amount of
cumulative revenue recognised will not occur once the uncertainty related to the variable
consideration is subsequently resolved. Examples of factors that could affect the likelihood or
the magnitude of a revenue reversal are:
• The susceptibility of the consideration to factors outside the entity’s influence, for
example, market volatility, actions of third parties, weather conditions or the risk of
product obsolescence;
• The period of uncertainty about the amount of consideration, for example, a 10-day
return period compared with a 90-day return period;
• The extent and predictive value of previous experience (or other evidence) with similar
types of contracts;
• Whether the entity has a practice of either offering a broad range of price concessions
or changing the payment terms and conditions of similar contracts in similar
circumstances; and
HKFRS • Whether the contract has a large number and broad range of possible consideration
15.57 amounts.
Illustrative Example 4
(This example is a continuation of the Illustrative Example 3.)
(Assume in this example that although the magnitude of the potential revenue reversal
is small compared with the estimated transaction price, it is significant when compared
with Granite’s estimated profit.)
Granite has experience in constructing office buildings. However, Granite observes that
its ability to complete the building by 30 June 20X1 is highly susceptible to factors outside
the entity’s influence, such as rain delays or union strikes. Consequently, Granite concludes
it cannot wholly include its estimate of variable consideration (HK$11.945 million) in the
transaction price because it cannot conclude it is highly probable a significant reversal in
the amount of cumulative revenue recognised will not occur. (I.e. Granite thinks there is
more than a low probability that it might earn a less consideration than HK$11.945 million.)
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Illustrative Example 4 (continued)
Based on its past experience with construction projects at this time of the year, the
weather forecasts and its relationship with the union, Granite determines it is highly
unlikely that the project will be delayed by more than four days. Consequently, Granite
determines that a significant reversal in the cumulative amount of revenue recognised
will probably not occur if it includes no more than HK$11.8 million in the transaction
price relating to this element. Using the expected value method and having regard to the
constraint, Granite estimates the transaction price relating to this element as:
Possible Probability Relative Consideration entitled to
consideration of outcome weighting
HK$11,800,000 50% 91%a HK$11,800,000 91% = HK$10,738,000
HK$11,750,000 5% 9%b HK$11,750,000 9% = HK$1,057,500
Estimated transaction price HK$11,795,500
a
Calculated as 91% = 50% / (50% 5%).
b
Calculated as 9% = 5% / (50% 5%).
Granite estimates the total transaction price on the contract to be HK$12,795,500
(HK$11,795,000 plus the HK$1 million incentive bonus).
Reassessment of Variable Consideration
An entity must update the estimated transaction price at the end of each reporting period. This
includes updating the entity’s assessment of whether an estimate of variable consideration is
no longer, or becomes, constrained due to changes in the probability that a significant reversal
in the amount of cumulative revenue recognised will occur. Any change to the estimated
transaction price is reflected in the measurement of revenue recognised in profit or loss
(see Section 5.2.4.4).
Updating the estimated transaction price is consistent with the financial report representing
HKFRS faithfully the circumstances present at the end of the reporting period and the changes in
15.59 circumstances during the reporting period.
Illustrative Example 5
(This example is a continuation of the Illustrative Example 4)
At reporting date 31 May 20X1, Granite reassesses its estimate of the transaction
price of its contract to construct a building for Marble. At this time, Granite now assesses
that there is:
• 6% probability the building will be completed three days before 30 June 20X1;
• 90% probability the building will be completed two days before 30 June 20X1; and
• 4% probability the building will be completed four days after 30 June 20X1.
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Illustrative Example 5 (continued)
Accordingly, Granite now considers it will probably be able to complete the building at
least two days ahead of the agreed date, that is, the previous constraint on the estimate of
variable consideration is no longer present. Granite re-estimates the variable consideration
related to this element to be HK$12.091 million (HK$12.15 million 6% HK$12.1 million
90% HK$11.8 million 4%).
Granite determines that it still expects to collect the incentive bonus. Consequently,
Granite updates its estimate of the transaction price to be HK$13.091 million (HK$12.091
million plus the HK$1 million incentive bonus) and reflects this in its measurement of
revenue recognised in profit or loss.
5.2.3.2 The Existence of a Significant Financing Component in the Contract
HKFRS 15 requires a significant financing component in a contract with a customer to be
separately accounted for from the promise to transfer goods or services. A contract contains a
significant financing component when the timing of payments agreed to by the parties to the
contract provides the customer or the entity with a significant benefit of financing the transfer
of goods or services to the customer. A contract does not contain a significant financing
component when:
• Goods or services are paid for in advance and the timing of the transfer of those goods
or services is at the customer’s discretion (e.g. prepaid phone cards, customer loyalty
points) – in these instances, the purpose of the payment terms does not relate to the
provision of financing;
• A substantial part of the consideration is dependent on the occurrence of future
events substantially outside the control of the customer or the entity (e.g. sales-based
royalties) – the primary purpose of the specified timing or amount of the payment
terms is to provide assurance of the value of the goods or services, rather than to
provide financing; or
• The difference between the consideration and the cash selling price of the good or
service does not relate to the provision of finance – the primary purpose of the
payment terms may be to provide the customer with assurance that the entity will
HKFRS complete its obligations satisfactorily under the contract, rather than to provide
15.62
HKFRS financing (e.g. the typical payment terms of an industry or jurisdiction may involve
15.BC233 deposit payments or milestone payments).
HKFRS A financing component may be explicitly stated in a contract or implied by the payment
15.60 terms agreed to by the parties to the contract. An entity considers all relevant facts and
circumstances in assessing whether a contract contains a significant financing component,
including:
• The difference, if any, between the amount of promised consideration and the cash
selling price of the promised goods or services; and
• The combined effect of both the (i) expected length of time between when the entity
HKFRS transfers the promised goods or services to the customer and when payment is due,
15.61 and the (ii) prevailing interest rates in the relevant market.
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A contract with a customer that includes a significant financing component is
separated into:
• A revenue component (for the notional cash sales price) – calculated by adjusting the
nominal consideration for the time value of money using a discount rate that would be
reflected in a separate financing transaction between the entity and its customer at
contract inception. The discount rate reflects the credit characteristics of the party
HKFRS receiving the financing benefit as well as any collateral or security provided and is not
15.61, 64 updated; and
• A loan component (for the effect of the deferred or advance payment terms) –
calculated as the difference between the nominal consideration and the amount of the
revenue component. This difference is recognised as interest revenue or interest
expense in accordance with HKFRS 9 Financial Instruments. Interest revenue or interest
HKFRS expense only arises from when an asset or liability relating to that contract with a
15.65 customer arises (e.g. a receivable, a contract asset or a contract liability).
Recall the discussion in Section 5.1 that the scope of HKFRS 15 excludes financial
instruments within the scope of HKFRS 9. Accordingly, as illustrated in Exhibit 5.8, the loan
component is excluded from the entity’s estimate of the transaction price of a contract.
separate into
components +
Contract Sale of goods Loan financing
$$$ to customer today accreting over time
$$ $
Included in HKFRS 9 specifies
transaction price the accounting
EXHIBIT 5.8 Separating the contract into its component parts
As a practical expedient, an entity need not adjust a contract with a customer for a
significant financing component where the financing period is expected to be one year or less.
Illustrative Example 6
Tellev enters into a contract to sell 10 mobile phone handsets at a cost of HK$3,600
per handset to customer Ching Hui. Under the contract terms, Ching Hui will receive
the handsets at contract inception but only pay for them in 24 months. Tellev sells the
handsets outright for HK$3,000 per handset. The handsets are non-refundable once
received by the customer.
Tellev determines the contract contains a significant financing component having
regard to the difference of HK$600 between the amount of promised consideration and
the cash selling price of the handsets, and the 24-month period between the sale and
payment and the prevailing market interest rate of 9.4% (which is commensurate with
the implicit interest rate in the contract of 9.54%): that is, the HK$600 difference looks like
the cost of finance. The implicit interest rate reflects the rate that would be reflected in a
separate financing transaction between Tellev and Ching Hui at contract inception.
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Illustrative Example 6 (continued)
In accordance with HKFRS 15, Tellev calculates the revenue component of the contract
to be HK$30,000 (calculated as HK$36,000 / (1 0.0954)2). This forms Tellev’s estimate
of the transaction price of the contract and is recognised as revenue in accordance
with HKFRS 15.
Tellev makes the following journal entries in relation to the contract:
At contract inception
Debit Credit
HK$ HK$
Accounts receivable 30,000
Revenue 30,000
(Recognition of revenue on satisfaction of the performance obligation)
At the end of Year 1
Debit Credit
HK$ HK$
Accounts receivable 2,863
Interest income 2,863
(Recognition of financing income in the contract in accordance
with HKFRS 9)
At the end of Year 2
Debit Credit
HK$ HK$
Accounts receivable 3,137
Interest income 3,137
(Recognition of financing income in the contract in accordance
with HKFRS 9)
and
Debit Credit
HK$ HK$
Cash 36,000
Accounts receivable 36,000
(Receipt of the payment due under the contract)
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5.2.3.3 Non-cash Consideration
Some contracts with customers may involve a form of barter, either completely or together
with cash consideration. When the promised consideration is in a form other than cash
(‘non-cash consideration’), an entity estimates the transaction price by:
• Measuring the non-cash consideration at its fair value (see Chapter 4); and
• Where the fair value of the non-cash consideration varies for reasons other than only
the form of the consideration, applying the variable consideration constraint discussed
in Section 5.2.3.1, that is, adjusting that amount to limit it to the amount that the entity
HKFRS considers highly probable not to give rise to a significant reversal in the amount of
15.66, 68 cumulative revenue recognised.
Examples of non-cash consideration include:
• Advertising services received in exchange for (dissimilar) advertising services
provided; and
• Receipt from customers of items of property, plant and equipment that must be used
to connect those customers to a utility network and provide them with access to
the utility.
HKFRS Non-cash consideration includes customer contributions of goods or services that facilitate
15.69 fulfilment of the contract if the entity obtains control of those goods or services.
An example of where fair value of the non-cash consideration varies because of the form of
HKFRS the non-cash consideration is a change in the price of a promised share. An example of where
15.68
HKFRS fair value varies other than only because of the form of the non-cash consideration is a change
15.BC254G in the exercise price of a share option because of the entity’s performance.
HKFRS 15 does not prescribe when the fair value of non-cash consideration is to be
measured, for example, at contract inception when the non-cash consideration is received or at
the earlier of when the non-cash consideration is received and when the related performance
HKFRS
15.BC254B– obligation is satisfied. Accordingly, an entity should make an accounting policy choice in this
254E regard and apply it consistently to its contracts with customers.
Where the entity cannot reasonably estimate the fair value of the non-cash consideration,
the transaction price is estimated by measuring the non-cash consideration indirectly by
HKFRS reference to the stand-alone selling price of the goods or services promised to the customer
15.67 (or class of customer) in exchange.
5.2.3.4 Consideration Payable to a Customer
The consideration payable to a customer includes amounts that an entity pays, or expects to
HKFRS pay, to the customer or its customer’s customers, either in the form of cash, credit or other
15.70 items (e.g. coupons or vouchers) that can be applied against amounts owed to the entity.
Where a contract with a customer includes consideration payable by the entity to the customer,
and that consideration payable:
• Includes a variable amount, the transaction price of the contract is estimated as
described in Section 5.2.3.1; and
HKFRS • In all other instances, the transaction price of the contract is reduced by the amount of
15.70 the consideration payable to the customer.
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In some instances, the payment to the customer may be made in exchange for distinct
goods or services that the customer transfers to the entity. This purchase transaction may or
may not be made within the same contract as the sale transaction; the transactions could be
linked even if they are separate events (see Section 5.2.1.2). In these cases, the reduction in the
transaction price is limited to the excess of the consideration payable to the customer over the
fair value of the goods or services transferred. However, if an entity cannot reasonably estimate
HKFRS the fair value of the good or service received from the customer, the transaction price is
15.70–71 reduced by the entire amount of the consideration payable to the customer.
Where the transaction price of a contract with a customer has been reduced by
consideration payable to the customer, the reduction of revenue is recognised when (or as) the
later of the following events occurs:
• The entity recognises revenue for the transfer of the related goods or services to the
customer; and
HKFRS • The entity pays or promises to pay the consideration (even if the payment is conditional
15.72 on a future event).
Illustrative Example 7
Tellev enters into a contract to sell mobile phone handsets for HK$2,500 per handset
to customer Whisky Limited (Whisky). Under the terms of the contract, Whisky commits
to purchase at least 50 handsets in a calendar year. The contract also requires Tellev
to make a non-refundable payment to Whisky of HK$10,000 at contract inception; this
amount will be used by Whisky to support its marketing campaign to sell the handsets.
Tellev concludes that the payment to Whisky is not in exchange for a distinct good or
service that transfers to the entity. This is because Tellev does not obtain control of any
rights to any assets of Whisky as a result of the payment. Consequently, Tellev determines
that the HK$10,000 payment should be treated as a reduction of the transaction price of
the contract.
In accordance with HKFRS 15, Tellev recognises the consideration payable as a
reduction in the transaction price, which affects revenue when the entity recognises
revenue for the transfer of the goods. Consequently, Tellev reduces the transaction price
for each handset transferred by HK$200. Therefore, when Tellev transfers 10 handsets to
Whisky, it recognises revenue of HK$23,000 (rather than HK$25,000).
5.2.4 Allocating the Transaction Price to the Performance Obligations
in the Contract – Step 4
The objective when allocating the transaction price is for an entity to ‘allocate the transaction
price to each performance obligation (or distinct good or service) in an amount that depicts the
HKFRS amount of consideration to which the entity expects to be entitled in exchange for transferring
15.73 the promised goods or services to the customer’. That is, the entity needs to ask, ‘How much I
have really sold each of these goods or services for?’.
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The allocation exercise will be straightforward when a contract with a customer includes
only a single performance obligation as in many instances when the entire transaction price
is allocated to that single performance obligation. However, the allocation exercise becomes
more complex when:
• A contract contains more than a single performance obligation; or
• Variability in the promised consideration relates to only some of the distinct goods
or services promised in a series of distinct goods or services forming part of a single
performance obligation.
HKFRS 15 requires the allocation of the transaction price to be based on the stand-alone
selling prices of the distinct promised goods or services. Allocating the transaction price in
HKFRS this manner is considered to faithfully depict the different margins applying to the promised
15.BC266 goods or services in most cases. Also, allocating the transaction price on a relative stand-
alone selling price basis can be said to bring rigour and discipline to the process of allocating
HKFRS the transaction price and, consequently, improve comparability within an entity and across
15.BC280 entities.
The remainder of this section discusses how to perform an allocation based on stand-alone
selling prices and how discounts and variable consideration affect the allocation.
5.2.4.1 Allocation Based on Stand-alone Selling Prices
HKFRS The transaction price is allocated to each performance obligation in proportion to the
15.76 stand-alone selling prices at contract inception of the distinct promised goods or services.
HKFRS The stand-alone selling price is the ‘price at which an entity would sell a promised good or
15.App A
service separately to a customer’. The transaction price is not reallocated to reflect changes in
HKFRS
15.88 stand-alone selling prices after contract inception.
The best evidence of a stand-alone selling price is the observable price of a good or service
when the entity sells that good or service separately in similar circumstances and to similar
HKFRS customers. A contractually stated price or a list price for a good or service may be (but shall not
15.77 be presumed to be) the stand-alone selling price of that good or service.
If a stand-alone selling price is not directly observable, the stand-alone selling price must be
estimated. The estimated stand-alone selling price demonstrates the following features:
• The amount results in the allocation of the transaction price meeting the allocation
objective.
• All information (including market conditions, entity-specific factors and information
about the customer or class of customer) that is reasonably available to the entity is
considered in making the estimate.
HKFRS
• The use of observable inputs is maximised in the estimate.
15.78
HKFRS • The estimation method is consistent with that used by the entity to estimate the
15.BC268 stand-alone selling price of other goods or services with similar characteristics.
Unlike HKFRS 13 Fair Value Measurement, this HKFRS does not specify a hierarchy of
HKFRS evidence that applies to determining the stand-alone selling price. However, the HKFRS does
15.BC274 require maximising the use of observable inputs in the estimate.
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HKFRS 15 does not prescribe any particular method for estimating a stand-alone selling
price. Nor does it preclude any method from being applied, so long as the method employed
HKFRS produces an estimate that faithfully represents the price at which the entity would sell the
15.BC268 distinct good or service separately. Methods for estimating the stand-alone selling price of a
good or service that is not directly observable include:
• Adjusted market assessment approach – an entity evaluates the market in which it sells
goods or services and estimates the price that a customer in that market would be
willing to pay for the goods or services. Under the approach, an entity could consider
competitor prices for similar goods or services and adjust those prices to reflect the
entity’s costs and margins;
• Expected cost plus a margin approach – an entity forecasts its expected costs of
satisfying a performance obligation and adds an appropriate margin for the good or
service; and
• Residual approach – an entity estimates the stand-alone selling price by reference to
the total transaction price less the sum of the observable stand-alone selling prices of
HKFRS other goods or services promised in the contract. The outcome of this approach cannot
15.79
HKFRS
realistically result in a stand-alone selling price of zero as a distinct good or service has
15.BC 273 value on a stand-alone basis.
Limitations on the Use of the Residual Approach
The residual approach may be used to estimate the stand-alone selling price of a good or
service only where the selling price of the good or service is highly variable or uncertain. The
entity either:
• Sells the same good or service to different customers at or near the same time for a
broad range of amounts, such that a representative stand-alone selling price is not
discernible from past transactions or other observable evidence; or
HKFRS • Has not yet established a price for a good or service that has not previously been sold
15.79 on a stand-alone basis.
The residual approach may be used even when two or more goods or services exist in a
contract with highly variable or uncertain stand-alone selling prices. In these instances, the
HKFRS entity could use another technique to disaggregate the amount determined using the residual
15.BC272 approach to estimate the stand-alone selling prices of goods or services.
5.2.4.2 Allocation of a Discount
The sale of a bundle of goods or services includes a discount if the sum of the stand-alone
selling prices of the promised goods or services exceeds the promised consideration. The
discount is allocated proportionately to all performance obligations in the contract on the basis
HKFRS of their relative stand-alone selling prices except where there is observable evidence that the
15.81 discount relates to only one or more, but not all, of the performance obligations in a contract.
In the promotional offer illustrated in Exhibit 5.9, the customer receives a discount of 50% of
the price of the second sofa if two sofas are purchased as part of the same transaction. As
there is no observable evidence that the discount relates to only some, but not all, of the
performance obligations in the contract (the promise to transfer a sofa), the discount is
allocated proportionately across each sofa based on the relative selling prices.
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Promotion! Buy 1 get the 2nd for 50% off
EXHIBIT 5.9 Discount in a contract with a customer
Where there is observable evidence that the discount relates to only one or more, but
not all, of the performance obligations in a contract, the discount is allocated only to those
performance obligations. Such an allocation method is used when:
• The entity regularly sells each distinct good or service in the contract on a stand-alone
basis;
• The entity also regularly sells on a stand-alone basis a bundle of some of those distinct
goods or services at a discount to the stand-alone selling prices of the goods or services
in each bundle; and
• The discount attributable to each stand-alone bundle of goods or services is
substantially the same as the discount in the contract and an analysis of the goods or
HKFRS services in each bundle provides observable evidence of the performance obligation
15.82 (or performance obligations) to which the entire discount in the contract belongs.
When the residual approach is used to estimate the stand-alone selling price of a good or
HKFRS service, the allocation of the discount to particular performance obligations must occur before
15.83 using the residual approach.
Key Learning Point
It may be inappropriate to allocate a discount on a contract with a customer proportionately
across all the performance obligations to be satisfied in that contract.
Apply and Analyse 3
Purple Limited (Purple) sells Mauve Limited (Mauve) and Violet Limited (Violet) a bundle
of goods comprising chocolates, hard candies and popcorn for HK$250 and HK$240,
respectively. Purple normally sells the hard candies and popcorn together for HK$80.
Purple is able to deliver each product at a different time.
The stand-alone selling prices of the products are:
Chocolates HK$170
Hard candies HK$60
Popcorn HK$40
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Apply and Analyse 3 (continued)
Calculate the allocation of the transaction price relating to each performance obligation
in the contracts with Mauve and Violet.
Analysis
Purple determines it has three performance obligations in each contract as the customer
can benefit from each good on its own, and each good is distinct in the context of
the contract.
With respect to Mauve, Purple determines that the entire amount of the discount of
HK$20 is allocable to only the hard candies and popcorn as (1) Purple regularly sells on
a stand-alone basis the hard candies and popcorn together at a discount to their stand-
alone selling prices; and (2) the discount attributable to hard candies and popcorn bundle
(HK$20) is substantially the same as the discount in the contract (in this case, also HK$20).
Accordingly, Purple determines the allocation of transaction price to be:
Promised good Allocation of transaction price
Chocolate HK$170
Hard candies HK$48 (calculated as HK$60/HK$100 HK$80)
Popcorn HK$32 (calculated as HK$40/HK$100 HK$80)
HK$250
With respect to Violet, although Purple regularly sells on a stand-alone basis the
hard candies and popcorn together at a discount to their stand-alone selling prices, it
determines that the discount in the contract of HK$30 should be allocable proportionately
to all performance obligations in the contract because the discount attributable to the hard
candies and popcorn bundle (HK$20) is not substantially the same as the discount in the
contract (HK$30). Accordingly, Purple determines the allocation of transaction price to be:
Promised good Allocation of transaction pricea
Chocolate HK$151 (calculated as HK$170/HK$270 HK$240)
Hard candies HK$53 (calculated as HK$60/HK$270 HK$240)
Popcorn HK$36 (calculated as HK$40/HK$270 HK$240)
HK$240
a
Rounding applied.
5.2.4.3 Allocation of Variable Consideration
Similarly to discounts, variable consideration may relate to satisfaction of the entire contract
or only to:
• One or more, but not all, performance obligations in the contract; or
HKFRS • One or more, but not all, distinct goods or services promised in a series of distinct
15.84 goods or services that forms part of a single performance obligation.
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The variable consideration is allocated entirely to a single performance obligation or to a
distinct good or service forming part of a single performance obligation only when:
• The terms of a variable payment relate specifically to the entity’s efforts to satisfy
that performance obligation or transfer that distinct good or service (or to a specific
outcome from satisfying that performance obligation or transferring that distinct good
or service); and
HKFRS • The allocation is consistent with the transaction price allocation objective, after
15.85 considering all of the performance obligations and payment terms in the contract.
For example, Gottime Limited (Gottime) signs a contract to clean Notime Limited’s (Notime)
head office for a two-year period. The contract terms provide that Gottime’s hourly rate will
increase based on changes to the consumer price index at the start of each subsequent annual
period in the contract term. The variable consideration in this contract is allocated only against
the services rendered in the second year of the contract as the variability relates only to the
HKFRS services promised in the second year of Gottime’s obligation to provide Notime with cleaning
15.84(b) services.
5.2.4.4 Changes in the Transaction Price
The transaction price in a contract could change subsequent to contract inception, for example,
on resolution of the uncertainty in variable consideration or as a result of a contract
modification. Any change in the transaction price of a contract is allocated to the performance
obligations on the same basis as at contract inception except for changes arising from a
modification to the contract (see Section 5.2.1.3). Changes in the transaction price allocated to
HKFRS satisfied performance obligations are recognised in profit or loss in the period in which the
15.87–88 transaction price changes.
Changes Occurring after a Contract Modification
A change in the transaction price that occurs after a contract modification is allocated
as follows:
• If the modification is accounted for as a termination of the original contract and
the creation of a new contract, then the subsequent change in the transaction price
will be allocated to the performance obligations identified in the contract before
the modification when, and to the extent that, the change is attributable to variable
consideration promised before the modification.
• In all other cases where the modification is not treated as a separate contract, the
HKFRS change in the transaction price is allocated to the performance obligations in the
15.90 modified contract.
5.2.5 Recognising Revenue When (or As) the Entity Satisfies a
Performance Obligation – Step 5
Exhibit 5.10 shows the five-step model. In Step 1 to Step 4 of the five-step approach, we
established the value that the entity places on its contract with a customer and on each
promise to transfer distinct goods or services within that contract, noting that the value
allocated to a promise may change during the course of a contract. The final step in the
five-step approach is when to recognise that value as revenue in profit or loss.
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Identify the Allocate the Recognise revenue
Identify the
performance Determine the transaction price when (or as) the
contract(s) with
obligations transaction price to performance performance
a customer
in the contract obligations obligation is satisfied
Steps 1–4: Established the value the entity places on the contract and on each obligation within the contract
EXHIBIT 5.10 Five-step model to recognising revenue
The discussion is set out as follows:
• Section 5.2.5.1. describes the revenue recognition principle, and explains the
accounting when consideration is received or receivable at a different time to the time
of satisfaction of the performance obligations in the contract.
• Sections 5.2.5.2 and 5.2.5.3 discuss how to identify whether a performance obligation is
satisfied over time or at a point in time, respectively.
• Section 5.2.5.4 considers methods of measuring progress towards satisfaction of a
performance obligation satisfied over time.
5.2.5.1 Satisfaction of Performance Obligations
HKFRS 15 describes the revenue recognition principle for contracts with customers, being for
revenue to be recognised:
when (or as) the entity satisfies a performance obligation by transferring a promised good or
service . . . to a customer
A performance obligation is satisfied when a promised good or service is transferred to a
customer. This may occur over time or at a point in time. For the purposes of HKFRS 15, the
promised good or service is transferred when (or as) the customer obtains control of the good or
service. A party has control of a good or service when the party has the ability to direct the use
HKFRS of, and obtain substantially all of the remaining benefits from, the good or service (even if only
15.33 momentarily).
Indicators that control may have been transferred from an entity to its customer include
the following:
• The entity has a present right to payment for the good or service.
• The customer has legal title to the good or service.
• The entity has transferred physical possession of the good or service.
• The customer has the significant risks and rewards of ownership of the good or service.
HKFRS
15.38 • The customer has accepted the good or service.
In assessing whether a customer has gained control of a good or service, an entity
HKFRS considers all relevant facts and circumstances, including the existence of any repurchase
15.34 arrangement.
The timing of satisfaction of a performance obligation differs from when consideration is
received or receivable
Revenue is recognised when (or as) the entity satisfies a performance obligation by transferring
a promised good or service to a customer. However, in many cases, consideration is received or
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receivable at a different time to when the performance obligation is satisfied. In some contracts
with customers, the entity may be compensated ahead of the transfer of the goods and
services; for example, Tellev receives compensation for its prepaid SIM card product offerings
before it delivers the service for data access, or a professional body may require annual
subscriptions to be paid in advance of the subscription year. In other contracts with customers,
the entity may receive compensation only after goods or services have been transferred to
the customer (e.g. a utility company that bills its customers for usage charges at the end of
each month receives payment only after the usage services have been rendered). In still other
contracts with customers, the entity may receive compensation payments at agreed points
during the contract duration; for example, in a long-term construction contract, the customer
may pay the entity a percentage of the contractual consideration on achievement of project
milestones.
As illustrated in Exhibit 5.11, when either party to a contract has performed, the entity
presents the contract in the statement of financial position as a contract asset or contract
liability (or refund liability), depending on the relationship between the entity’s performance
HKFRS and the customer’s payment. Any unconditional rights to consideration are shown separately
15.55, 105 as a receivable, which is accounted for in accordance with HKFRS 9.
Performance Refund liability
Consideration received > = Contract liability or
obligations satisfied (amounts the entity expects to refund)
Performance Receivable
Consideration received < = Contract asset or
obligations satisfied (unconditional right to consideration)
EXHIBIT 5.11 Timing of considerations varies from timing of satisfaction of the performance
obligation
A contract liability is an entity’s obligation to transfer goods or services to a customer
for which the entity has received consideration (or the amount is due) from the customer.
A contract asset is an entity’s right to consideration in exchange for goods or services that the
entity has transferred to a customer when that right is conditioned on something other than
the passage of time.
Some entities may already record and report on balances similar to the HKFRS 15 contract
asset or contract liability but describe the balances as ‘due from customers’ or ‘unbilled
accounts receivable’ and ‘due to customers’ or ‘deferred revenue’. HKFRS 15 permits an entity
HKFRS to continue using such descriptions rather than ‘contract asset’ and ‘contract liability’ as long as
15.109
HKFRS the amounts are determined in accordance with HKFRS 15. In addition, the contract asset must
15.BC346 be distinguishable from receivables.
Refund liability
An entity recognises a refund liability when it receives consideration from a customer but
expects to refund some or all of that consideration back to the customer. A refund liability
is measured at the amount of consideration received (or receivable) for which the entity does
not expect to be entitled (i.e. the amounts that are not included in the transaction price). To
the extent that a refund liability is recognised, a contract liability is not recognised in relation to
consideration received from a customer.
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The refund liability is updated at the end of each reporting period for changes in
HKFRS circumstances. Updating the refund liability will result in changes to a contract’s transaction
15.55 price (see Section 5.2.4.4) and therefore, the amount of the contract liability recognised.
Illustrative Example 8
Liquid Limited (Liquid), a retail water business, enters into a contract to supply water to
customer Qin. Under the terms of the contract, Qin pays for the water consumption at the
end of each three-month billing cycle. The contract also requires Qin to pay a water service
and sewerage service charge that is charged by calendar quarter. The water service and
sewerage charge are non-refundable in the event Qin cancels the contract with Liquid.
On 9 May, Liquid issues an invoice to Qin for HK$791.29 for the water usage between
6 February and 8 May and for water service and sewerage service charges for the period
1 April to 30 June.
Liquid makes the following journal entries on 9 May reflecting its partial satisfaction of
the performance obligations in the contract, and its entitlement to consideration at that time:
Usage Charges
Meter number Bill days Previous Current Consumption Rate $ Total $
Reading Reading in kilolitres
MAF316795 92 4594 4741 147.00 (meter read date: 08/05/2018)
Total Water Consumed Services rendered (i.e. performance
Usage Step 1 (06/02/2018 to 08/05/2018) 40.48 2.4440 $98.93
obligation satisfied) but consideration
not yet received
Usage Step 2 “ ” 40.48 2.8766 $116.44
DR Receivable HK$669.35
Usage Step 3 “ ” 66.04 4.2744 $282.28
CR Revenue HK$669.35
Total 147.00 $497.65
Sewage Disposal 91.31 1.8805 $171.70
Total $171.70
Consideration receivable
TOTAL USAGE CHARGES $669.35 before performanceobligation
is fully satisfied
Service Charges DR Receivable HK$121.94
Water Service Charge (01/04/2018 to 30/06/2018) $57.80 CR Contract liability HK$71.02
Sewerage Service Charge (01/04/2018 to 30/06/2018) $64.14 CR Revenue HK$50.92
(HK$121.94 x 38/91days)
TOTAL SERVICE CHARGES $121.94
The contract liability will be
derecognised over the period
9/5 to 30/6 as the performance
obligation is satisfied
DR Contract liability HK$71.02
CR Revenue HK$71.02
5.2.5.2 Performance Obligations Satisfied Over Time
At contract inception, an entity establishes whether it satisfies each identified performance
obligation:
• over time; or
• at a point in time.
Nuances in the terms of similar contracts may lead to different determinations of whether a
performance obligation is satisfied over time or at a point in time.
When an entity transfers control of a promised good or service to the customer over time,
it satisfies the performance obligation over time. Revenue is recognised as the performance
obligation is satisfied, that is, over time (e.g. over the duration of the contract).
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Exhibit 5.12 describes when the transfer of a good or service occurs over time in
accordance with HKFRS 15.
Does the customer simultaneously
receive and consume the benefits
Indicators of whether control is being passed
YES
provided by the entity’s performance
as the entity performs under the
contract? (e.g. cleaning services)
NO
Does the entity’s performance create
or enhance an asset that the customer YES The performance obligation is satisfied over time.
controls as the asset is created or Recognise revenue over time
enhanced? (e.g. work in progress)
NO
Does the entity’s performance create
an asset with no alternative use to the YES
entity and does the entity have an
enforceable right to payment for
performance completed to date?
NO
The performance obligation is satisfied at a point in time.
Recognise revenue at a point in time
(see Section 2.6.3)
EXHIBIT 5.12 Evaluating whether the transfer of a good or service occurs over time
The determination of whether the asset has an alternative use to the entity is made at
contract inception and is not changed unless a substantive contract modification occurs. An
asset created by an entity’s performance does not have an alternative use to the entity if the
entity is either:
• Restricted contractually from readily directing the asset for another use during
the creation or enhancement of that asset. The contractual restriction must be
substantive; or
HKFRS
• Limited practically from readily directing the asset in its completed state for
15.36 another use.
The right to payment for performance completed to date does not need to be for a fixed
amount, but the entity must be entitled at all times throughout the duration of the contract to
an amount that at least compensates it for performance completed to date if the customer
terminates the contract (except where a contract is terminated for performance reasons). An
amount that compensates the entity for performance completed to date is an amount that
approximates the selling price of the goods or services transferred to date, for example, the
HKFRS
recovery of the costs incurred by the entity in satisfying the performance obligation plus a
15.37, B9 reasonable profit margin.
If an entity determines it satisfies a performance obligation over time, it will have to
determine how to measure its progress towards satisfaction of that performance obligation.
This is discussed in Section 5.2.5.4.
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Apply and Analyse 4 – Adapted from HKFRS 15 Illustrative Examples,
Example 17
Granite Limited (Granite) is developing an apartment block. It enters into a contract
with customer Agate Limited (Agate) to sell Agate Apartment 314 in the building under
construction. Agate pays a deposit upon entering into the contract which is refundable only
if Granite fails to complete construction in accordance with the contract. The remainder of
the contract price is payable when the Agate obtains physical possession of the unit.
Determine whether the performance obligation is satisfied over time or at a point in time.
Analysis
Granite has a single performance obligation in its contract with Agate, being its promise to
transfer Apartment 314 to Agate. Granite determines that the performance obligation is
satisfied at a point in time because none of the criteria in HKFRS 15 for the performance
obligation to be satisfied over time are met. This is because:
• Agate does not simultaneously receive and consume the benefits provided by
Granite’s performance as Granite performs under the contract because the
contract is for the sale of a good;
• Granite’s performance does not create an asset that Agate controls during the
build because possession only transfers to Agate on completion of the unit; and
• Granite’s performance creates an asset with alternative use to Granite, because
Granite could conceivably sell the apartment to another party than Agate.
However, in the event of Agate terminating the contract for reasons other than
Granite’s non-performance, Granite would only be entitled to retain the initial
deposit. Accordingly, Granite does not have an enforceable right to payment for its
performance on the build until construction is complete.
5.2.5.3 Performance Obligations Satisfied at a Point in Time
As highlighted in Exhibit 5.12, where a performance obligation is not satisfied over time, it
is said to be satisfied at a point in time. Revenue is recognised at the point in time when the
customer gains control of the distinct goods or services transferred because this is the time
when the performance obligation is satisfied.
5.2.5.4 Measuring Progress Towards Complete Satisfaction of a Performance Obligation
Where a performance obligation is satisfied over time, an entity recognises revenue over time
by measuring the entity’s progress towards complete satisfaction of that performance
HKFRS obligation. Revenue is recognised only when the entity can reasonably measure its progress
15.39, 45 towards complete satisfaction of the performance obligation.
In some circumstances (e.g. in the early stages of a contract), an entity may not be able to
reasonably measure the outcome of a performance obligation but expects to recover costs
incurred (see Section 5.3). In those circumstances, the entity recognises revenue only to the
HKFRS extent of the costs incurred until such time that it can reasonably measure the outcome of the
15.45 performance obligation.
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For each performance obligation satisfied over time, an entity:
• Applies a single method of measuring progress in satisfying that performance
obligation;
• Applies that method consistently to similar performance obligations and in similar
circumstances; and
HKFRS • Remeasures, at the end of each reporting period, its progress towards complete
15.40 satisfaction of the performance obligation. Any change to an entity’s measure of
progress (to reflect changes in the outcome of the performance obligation) is treated as
HKFRS a change in accounting estimate in accordance with HKAS 8 Accounting Policies, Changes
15.43 in Accounting Estimates and Errors.
Selecting a Method for Measuring Progress
The objective when measuring progress towards complete satisfaction of a performance
HKFRS obligation is to depict the entity’s performance in transferring control of goods or services
15.39 promised to a customer, i.e. the satisfaction of the entity’s performance obligation. Accordingly,
an entity considers the nature of the promised good or service when selecting a method of
HKFRS measuring progress towards satisfaction of the performance obligation. Only goods and
15.41–42 services for which control is transferred are included in the measure of progress.
Appropriate methods for measuring progress include output and input methods. These
methods are commonly regarded as ‘percentage of completion’ or ‘stage of completion’
methods. (HKFRS 15 does not use the terms ‘percentage of completion’ or ‘stage of
completion’.) Exhibit 5.13 explains these methods.
Output methods Input methods
Recognises Direct measurements of the value to The entity’s efforts or inputs to
revenue on the the customer of the goods or services the satisfaction of a performance
basis of . . . transferred to date relative to the remaining obligation relative to the total
goods or services promised under expected inputs to the satisfaction of
the contract that performance obligation
Examples • surveys of performance • proportion of expected
completed to date resources consumed
• appraisals of results achieved • proportion of expected of labour
• milestones reached hours expended
• time elapsed • proportion of expected
• units produced costs incurred
• units delivered • proportion of expected time
elapsed or machine hours used
Advantages Conceptually, outputs more faithfully depict Inputs may be more directly
performance because they directly measure observable and less costly to measure
the value transferred to the customer than outputs
Disadvantages Outputs used to measure progress may There may not be a direct relationship
not be directly observable and may be between inputs and the transfer of
costly to obtain control of goods or services
EXHIBIT 5.13 Methods for measuring progress of a performance obligation (Source: HKFRS 15.B15-B19,
HKFRS 15.BC164.)
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As a practical expedient, an entity that has a right to consideration from a customer in an
amount that corresponds directly with the value to the customer of the entity’s performance
completed to date; for example, a service contract in which an entity bills a fixed amount for
HKFRS
15.B16 each hour of service provided may recognise revenue in the amount to which the entity has a
HKFRS right to invoice. Also, if an entity’s efforts or inputs are expended evenly throughout the
15.B18 performance period, the entity may recognise revenue on a straight-line basis.
Knowledge Check Questions
Question 3
On 1 January 20X0, a hardware store, Beta Hardware, enters into an arrangement with a
hardware supplier, Hardware Distribution Plus. Under the arrangement, Beta Hardware is
entitled to purchase certain lines of stock at an agreed upon price for a period of 24 months.
Beta Hardware and Hardware Distribution Plus are entitled to cancel the contract
at any time without compensating the other party other than in relation to repaying
outstanding debts as at the date the contract is cancelled.
As at 15 January 20X0, Beta Hardware had made no orders. For the purposes of
HKFRS 15, does a contract with a customer exist? Explain your response.
Question 4
Identify which one of the following criteria is not required to account for a contract with a
customer in accordance with HKFRS 15.
A The contract has been approved by all relevant parties.
B Each party’s rights to goods or services to be transferred are identifiable.
C Goods or services have been transferred.
D The contract has commercial substance.
Question 5
Alpha Limited enters into a contract with customer Yolo Limited to deliver 30,000 widgets
over a three-year period. Part way through the contract, the terms of the contract are
modified such that Alpha Limited will deliver an additional 5,000 widgets, where the
increase in consideration to which Alpha Limited is entitled reflects the stand-alone selling
price of the widgets.
Determine how Alpha Limited should account for the contract modification.
A Treat the modification as a termination of the existing contract and the creation of a
new contract.
B Treat the modification as a separate contract from the original.
C Treat the modification as an adjustment to the existing contact.
D Treat the modification partly as an adjustment to the existing contract and partly as the
creation of a new contract.
Question 6
A construction company enters into a contract with a customer to deliver a shopping mall.
The construction company is responsible for the engineering, site levelling, base structure,
construction and installation of all required fixtures and fittings.
Determine the performance obligations in this contract. Justify your response.
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Knowledge Check Questions (continued)
Question 7
Zoom, an energy retailer, sells electricity and invoices its customers monthly for the
electricity consumed in the previous month. Determine whether Zoom is likely to recognise
revenue from the sale of electricity to its customers over time or at a point in time.
Question 8
A large telecommunications company provides a discount of between 0–20% to its
customers. The size of the discount varies depending on when a customer pays his or
her monthly bill. Assuming the telecommunications company groups its contracts into
portfolios for the purposes of applying HKFRS 15, identify which one of the following
methods is most likely to be an appropriate measurement technique to estimate the
transaction price of the contracts.
A The most likely amount
B The expected value
C The billed amount
D The average amount
Question 9
A manufacturer enters into a contract to provide 1,000 kettles to a retailer over a 24-month
period. In exchange for the kettles, the retailer will pay the manufacturer HK$50 per kettle.
To entice the retailer to sell its products, the manufacturer pays the retailer HK$2,500 to
rework its shelving to accommodate the display of the kettles. Identify which one of the
following statements is correct.
A The manufacturer immediately recognises HK$2,500 as an expense.
B The transaction price of the contract is HK$47,500.
C The manufacturer recognises the shelving as property, plant and equipment.
D The transaction price of the contract is HK$50,000.
Question 10
A telecommunications company enters into a 24-month contract with a customer. In
accordance with the contract, the customer will receive a handset at contract inception and
25GBs of data allowance each month at a cost of HK$480 per month. Also, as the customer
enters into the contract during a promotional period, the customer will be entitled to
receive a free tablet computer at contract inception.
The telecommunications company assesses the stand-alone selling price of the
handset to be HK$4,536 and the stand-alone selling price of the data allowance to be
HK$315 per month. The stand-alone selling price of the tablet computer is $3,024.
Calculate an appropriate allocation of the transaction price for each performance
obligation in the contract.
Question 11
Question 11 is a continuation from Question 10. Using the facts in Question 10, calculate
the cumulative revenue recognised by the telecommunications company at the end of 12
months into the contract.
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5 . 3 CONTRACT COSTS
In most cases, an entity will incur costs in transacting with customers. HKFRS 15 specifies the
accounting for the costs of obtaining a contract and the costs of fulfilling a contract where the
accounting for that cost is not within the scope of another HKFRS.
5.3.1 Costs of Obtaining a Contract
The costs of obtaining a contract with a customer that is ‘consideration payable to a
customer’ is treated as a reduction of the transaction price in accordance with HKFRS 15
(see Section 5.2.3.4). Other costs of obtaining a contract with a customer are recognised as an
asset when the costs are:
• Incremental costs (i.e. the costs would not have been incurred if the contract had
not been obtained) and the entity expects to recover the costs, for example, through
reimbursement or the margin on the contract; or
HKFRS • Not incremental costs (i.e. the costs would have been incurred regardless of whether
15.91–93 the contract was obtained) but are explicitly on-chargeable to the prospective customer.
HKFRS However, as a practical expedient, an entity is permitted to immediately expense
15.94 incremental costs that would have otherwise been amortised over one year or less.
Other costs to obtain a contract are expensed when incurred unless they qualify for
capitalisation in accordance with another HKFRS.
Apply and Analyse 5 – Adapted from HKFRS 15 Illustrative Examples,
Example 36
A consulting services entity incurred the following costs to obtain a contract to provide
consulting services to a new customer:
External legal fees for due diligence HK$15,000
Travel costs to deliver proposal HK$5,000
Commissions to sales employees HK$30,000
As part of the tender process, the customer agreed that it would reimburse the entity’s
travel costs up to HK$4,500 as it required the entity to make its presentation for the bid at
the customer’s head office overseas.
Determine the costs, if any, that are capitalisable in accordance with HKFRS 15.
Analysis
The entity recognises an asset in relation to the HK$30,000 sales commissions because
these costs would not have been incurred if the entity had not obtained the contract and
the entity expects to recover the costs through future fees for the consulting services.
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Apply and Analyse 5 (continued)
The entity also recognises an asset for HK$4,500 of the travel costs because, though these
costs would have been incurred regardless of whether the contract was obtained, the
entity is able to recover them from the customer.
The balance of the travel costs and the external legal fees would have been incurred
regardless of whether the contract was obtained and, accordingly, cannot be recognised as
an asset. These costs are expensed as incurred.
5.3.2 Costs to Fulfil a Contract
Any costs incurred in fulfilling a contract with a customer that are within the scope of another
HKFRS HKFRS (e.g. HKAS 2 Inventories, HKAS 16 Property, Plant and Equipment and HKAS 38 Intangible
15.96 Assets) are recognised in accordance with that other HKFRS.
Any costs incurred in fulfilling a contract with a customer that are not within the scope of
another HKFRS are recognised as an asset in accordance with HKFRS 15 only when those costs:
• Relate directly to a specifically identifiable contract or anticipated contract;
• Generate or enhance resources of the entity that will be used in satisfying (or in
continuing to satisfy) performance obligations in the future; and
HKFRS
15.95 • Are expected to be recovered.
Costs that ‘relate directly’ to a contract include:
• Direct labour;
• Direct materials;
• Allocations of costs that relate directly to the contract or to contract activities (e.g.
costs of contract management and supervision, insurance and depreciation of tools,
equipment and right-of-use assets used in fulfilling the contract);
• Costs explicitly chargeable to the customer under the contract; and
HKFRS • Other costs incurred only because an entity entered into the contract (e.g. payments to
15.97 subcontractors).
Costs incurred in fulfilling a contract with a customer that are expensed as incurred include:
• General and administrative costs unless those costs are explicitly chargeable to the
customer under the contract;
• Costs of wasted materials, labour or other resources to fulfil the contract that were not
reflected in the price of the contract;
• Costs that relate to past performance; and
HKFRS • Costs for which an entity cannot distinguish whether the costs relate to unsatisfied
15.98 performance obligations or to satisfied (or partially satisfied) performance obligations.
5.3.3 Amortisation and Impairment
Capitalised contract costs are subject to amortisation and impairment. Amortisation is made on
a systematic basis consistent with the transfer to the customer of the goods or services to
which the asset relates. The amortisation profile is updated to reflect a significant change in the
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HKFRS entity’s expected timing of transfer to the customer of the goods or services to which the asset
15.99–100 relates; this is treated as a change in an accounting estimate.
Capitalised contract costs are impaired when their carrying amount exceeds:
• The remaining amount of consideration entity expects to receive in exchange for the
goods or services to which the asset relates;
less
• The capitalised costs incurred in fulfilling a contract that relate directly to providing
those goods or services.
‘The remaining amount of consideration the entity expects to receive’ is estimated using the
principles for estimating transaction price but ignoring any constraints on estimates of variable
HKFRS consideration and allowing for customer credit risk. Estimating the amount in this manner is
15.102
HKFRS consistent with the impairment objective of determining whether the carrying amount of the
15.BC310 contract acquisition and fulfilment costs asset is recoverable.
HKFRS Any impairment loss (or reversal thereof) is recognised as an expense (or reversal thereof)
15.101, 104 in profit or loss.
Knowledge Check Questions
Question 12
Determine which one of the following statements is true.
A An entity has an accounting policy choice whether to capitalise or immediately expense
all costs of fulfilling a contract.
B An entity has an accounting policy choice whether to capitalise or immediately expense
all costs of obtaining a contract.
C The transaction price is reduced by the amount of any capitalised contract costs.
D Only costs that are expected to be recoverable may be recognised as an asset.
Question 13
On 1 January 20X1, Armadale Limited (Armadale) has capitalised the following costs related
to a two-year contract with customer Kew:
Sales commissions HK$10,000
Wages of staff working solely on the contract HK$50,000
Armadale measures progress of the contract using the ‘basis of costs incurred’ method.
At reporting date 31 December 20X1, Armadale assesses that the contract with Kew is
40% complete and recognises revenue of HK$48,000. On 15 February 20X2, Armadale
determines Kew will likely default on the contract and not make any payment. Armadale
did not incur any further costs between 31 December 20X1 and 15 February 20X2.
Determine which one of the following statements is true.
A Armadale recognises HK$30,000 as amortisation expenses.
B Armadale recognises HK$48,000 as amortisation expenses.
C Armadale recognises an impairment loss of HK$36,000.
D Armadale reverses the revenue recognised to date of HK$48,000.
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5 . 4 OTHER REVENUE RECOGNITION ISSUES
In Section 5.2, you were introduced to the five-step model and how each step applies. Now
that you are familiar with the model, we will discuss some of the complexities in applying it.
By the end of this section, you will gain an appreciation of considerations to be aware of when
evaluating the accounting for a contract with a customer, including possible complexities in:
• Identifying the distinct promised good or service to be transferred, including identifying
and accounting for services that are not explicit in the contract
• Whether or when control of a good or service is transferred (i.e. when the performance
obligation is satisfied)
• How variable consideration in the form of royalties relating to licences of intellectual
property is treated.
Also, earlier, you learnt that only the part of a contract that is not addressed by another
HKFRS is addressed by HKFRS 15 (i.e. results in the recognition of revenue in accordance
with HKFRS 15). In this section, we highlight that other HKFRS such as HKAS 37 Provisions,
Contingent Liabilities and Contingent Assets may additionally apply to the contract accounted for
in accordance with HKFRS 15.
5.4.1 Sale with a Right of Return
An entity may transfer control of a product to a customer and also grant the customer the
right to return the product for a refund or a credit note. These rights of return are common
in certain industries or jurisdictions, for example, the retail sector. Conceptually, the entity
has two performance obligations in such instance: the promise to deliver the product and the
promise to stand ready to accept a returned product; however, HKFRS 15 specifies that the
promise to stand ready to accept a returned product is not treated as a performance obligation
in addition to the obligation to provide a refund.
Recall that the transaction price (and hence, revenue) includes only the amount of
consideration to which the entity expects to be entitled in exchange for transferring the
promised goods and services. Where an entity expects promised goods and services to be
returned, it also does not expect to be entitled to the corresponding amount of consideration.
Accordingly, for a sale with a right of return, an entity recognises:
• Revenue for the transferred products in the amount of consideration to which the
entity expects to be entitled (therefore, revenue is not recognised for the products
expected to be returned);
• A refund liability for any amounts received or receivable for which the entity does not
expect to be entitled; and
HKFRS • An asset (and a corresponding adjustment to cost of sales) for its right to recover
15.B21 products from customers on settling the refund liability.
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The asset recognised for an entity’s right to recover products from a customer on settling a
refund liability is initially measured by reference to the pre-sale carrying amount of the product
HKFRS (e.g. its inventory carrying amount) less any expected costs to recover those products, including
15.B25 potential decreases in the value to the entity of returned products.
Key Learning Point
Revenue is not recognised at the time control of the product passes to the customer for
the products expected to be returned.
At the end of each reporting period, the entity updates:
• Its assessment of amounts for which it expects to be entitled in exchange for the
HKFRS
transferred products and makes a corresponding change to the transaction price and,
15.B23 therefore, in the amount of revenue recognised;
• The measurement of the refund liability for changes in expectations about the amount
HKFRS
of refunds. The corresponding adjustment is recognised as an increase or reduction of
15.B24 revenue; and
HKFRS
• The measurement of the asset arising from changes in expectations about products to
15.B25 be returned.
The following Illustrative Example illustrates the accounting for a simple sale with a right of
return period. In this example, because the period of the right to return is short the entity does
not update any of its initial assessments.
Illustrative Example 9 – Adapted from HKFRS 15 Illustrative Examples,
Example 22
On 1 June 20X0, Tellev sells 100 handphone ‘jewels’ for HK$50 per product to customers.
Cash is received when control of the ‘jewels’ transfers to the customers. Tellev’s refund
policy is to allow a customer to return any unused product within 14 days and receive a
full refund. Each ‘jewel’ costs Tellev HK$10 to produce.
Tellev applies the requirements in HKFRS 15 to the portfolio of 100 contracts as it
reasonably expects that the effects on the financial statements from applying these
requirements to the portfolio would not differ materially from applying the requirements
to the individual contracts within the portfolio. It estimates the transaction price of the
contracts using the expected value method to estimate the variable consideration in the
contracts. Under this method and having regard to constraints on the amount of variable
consideration, Tellev estimates that five ‘jewels’ will be returned for a refund. (For the
purposes of this example, assume the costs of recovering any ‘jewels’ are immaterial,
Tellev is able to resell any returned products at a profit and Tellev makes no change to its
assessment of the number of products that will be returned.)
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Illustrative Example 9 (continued)
During the 14-day return period, four ‘jewels’ are returned to Tellev.
Tellev recognises the following journals in relation to these contracts:
At contract inception
Debit Credit
HK$ HK$
Cash 5,000
(100 products HK$50 = HK$5,000)
Refund liability 250
(5 products HK$50 = HK$250)
Revenue 4,750
(95 products HK$50 = HK$4,750)
(Sale of ‘jewels’)
and
Debit Credit
HK$ HK$
Cost of sales HK$1,000
(100 products HK$10 = HK$1,000)
Inventory HK$1,000
(Decrease in inventory)
and
Debit Credit
HK$ HK$
Right to recover product 50
(5 products HK$10 = HK$50)
Cost of sales 50
(Right to recover ‘jewels’ on settling the refund liability)
As products are returned during the refund period
Debit Credit
HK$ HK$
Refund liability 200
(4 products HK$50 = HK$200)
Inventory 40
(4 products HK$10 = HK$40)
Cash 200
Right to recover product 40
(Total journal recognised reflecting the actual return of ‘jewels’)
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Illustrative Example 9 (continued)
When refund period expires
Debit Credit
HK$ HK$
Cost of sales 10
(1 products HK$10 = HK$10)
Refund liability 50
(4 products HK$10 = HK$40)
Right to recover product 10
Revenue 50
(To recognise the adjustment to the transaction price required now that the uncertainty in
the variable consideration has been resolved.)
5.4.2 Warranties
In some industries (e.g. the retail sector) or jurisdictions, it may be common for the seller or
manufacturer to offer a warranty guaranteeing the functionality of the transferred good or
service. A warranty is a promise to the customer that a good or service will perform as intended
for at least a stated period; that is, it offers the customer assurance about the good or service.
An example is a one-year manufacturer warranty that is bundled with the item sold. Some
warranties also offer a service to the customer because that warranty further extends the
functionality of the good or service, for example, a store warranty that can be purchased at
the time of buying the good or service to extend the term of the warranty from one year to
three years.
Customer can purchase the warranty separately in connection with the sale
of a product
Recall that HKFRS 15 requires all performance obligations (the distinct promised goods and
services) in a contract with a customer to be identified. Where a customer can purchase a
warranty separately in connection with the sale of a product (e.g. an extended warranty or a
store warranty), the entity has promised to provide a warranty service to the customer. The
warranty represents a distinct service and is treated as a separate performance obligation in
the contract with the customer.
These warranties are described as ‘service-type warranties’ and are accounted for in
accordance with HKFRS 15. An allocation of the transaction price must be made to the warranty
HKFRS service and recognised as revenue when or as the performance obligation is satisfied (in many
15.B29 cases, the performance obligation is likely to be satisfied over time).
(Note: Accounting for service-type warranties in accordance with HKFRS 15 is an accounting
policy election many entities are expected to make in practice: The warranty is otherwise
treated in accordance with HKFRS 17 Insurance Contracts. For the purposes of teaching this
chapter, we will assume that HKFRS 15 rather than HKFRS 17 applies.)
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Customer does not have the option to purchase a warranty separately from the product
Where a customer does not have the option to purchase a warranty separately (e.g. a standard
warranty), the warranty is:
• Recognised and measured in accordance with HKAS 37 Provisions, Contingent Liabilities
and Contingent Assets
unless
• The promised warranty (or component thereof) provides the customer with a service
(e.g. maintenance) in addition to the assurance that the product complies with agreed-
upon specifications.
If a warranty provides a customer with a service in addition to the assurance that the
HKFRS product complies with agreed-upon specifications, the promised service is a performance
15.B30, B32 obligation.
An entity that cannot reasonably separate the service component from an assurance-type
warranty accounts for both together as a separate performance obligation; this accounting
treatment ensures the entity does not overstate the recognition of revenue at the time that the
HKFRS product transfers to the customer and also relieves the entity from identifying and accounting
15.BC376 separately for the two components of the warranty.
A service is less likely to be a performance obligation if (1) the warranty is for a shorter
period, (2) is required by law or (3) if the tasks that the entity has promised to perform under
HKFRS the warranty are tasks necessary to provide assurance that a product complies with agreed-
15.B31 upon specifications, for example, a return shipping service for a defective product.
The accounting for warranties is summarised in Exhibit 5.14.
• The ‘good’ includes assurance-type warranties
• Warranty is measured in accordance with HKAS 37
(warranty provision/expense)
he
tify t ns • Total obligation of the entity may be greater than
Iden obligatio the transaction price of the contract (as the HKAS 37
a n c e Sale of goods
m
perfor to customer liability is separate to the contract)
$$ • Revenue recognition is not affected by the warranty
per I
formdentif
anc y the
Contract eo
blig • Service-type warranties
atio
$$$ ns • Assurance-type warranties with service-type features
• Warranty is measured in accordance with HKFRS 15
(contract liability until revenue recognition criteria met)
Warranty • Total obligation of the entity is limited to the transaction
service price of the contract (as the warranty service forms part
$ of the contract)
• Warranty may change the timing of revenue recognition
on the contract
EXHIBIT 5.14 Accounting for warranties
Illustrative Example 10
In addition to its refund for change of mind policy, Tellev offers its customers the
option to purchase its ‘Gold Class Extended Warranty’ service, which extends by a year
the existing manufacturer’s warranty on an item. The item is replaced or repaired at
the discretion of the warranty provider. The store warranty starts at the end of the
manufacturer warranty period.
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Illustrative Example 10 (continued)
On 1 October 20X0, Tellev sells a customer a Tellev-branded handphone. Tellev
provides a two-year manufacturer’s warranty on the handphone, which it is obliged to
do by law. Under the terms of the manufacturer’s warranty, Tellev must repair or replace
a defective handphone and bear the costs of collecting and returning the item to the
customer. The customer also purchases Tellev’s Gold Class Extended Warranty product
over the item. The total payment made by the customer is HK$3,500, comprising HK$2,800
for the handphone and HK$700 for the warranty. (For the purposes of this example,
assume the item price and warranty price represent their stand-alone selling prices.)
Applying Step 2
Tellev identifies that the following performance obligations are present in the contract:
• Promise to transfer a handset – As the handset is routinely sold separately
from the extended warranty, Tellev concludes the customer can benefit from
the handset on its own (or together with other resources such as mobile phone
services) and that the handset is separately identifiable from the other promises
in the contract. Tellev observes that implicit in the promise to transfer a handset is
the promise to transfer a manufacturer’s warranty; the warranty is an assurance-
type warranty that is not distinct from the handset because the warranty provides
the customer with the assurance the handphone will function as intended for
two years, is not sold separately from the handphone and does not provide the
customer with a good or service in addition to that assurance.
• Promise to transfer a store warranty – Tellev concludes the warranty is a distinct
service-type warranty because the warranty is sold separately from the handphone
and provides the customer with repair or replacement services for a year beyond
the manufacturer guaranteed period.
Tellev assesses that the manufacturer’s warranty does not provide the customer with a
service in addition to the assurance the product complies with agreed-upon specifications
because, although it is for a slightly longer period (two years), the warranty is required by
law and the nature of the tasks under the warranty are only tasks necessary to provide
assurance that the product complies with its agreed-upon specifications.
Applying Step 3 to Step 5
In accordance with HKFRS 15, Tellev allocates the transaction price of HK$3,500 between
the promise to transfer a handset and promise to transfer a warranty service, in proportion
to their stand-alone selling prices. In this example, this is HK$2,800 and HK$700,
respectively. The portion of the transaction price allocated to the promise to transfer:
• A handset is recognised as revenue on 1 October 20X0 because Tellev transfers
control of the good to the customer on this date, i.e. satisfies the performance
obligation. (A refund liability is recognised instead of revenue if Tellev expects the
customer to return the product.)
• A store warranty is recognised as revenue over the period 1 October 20X2 to
30 September 20X3 as the customer simultaneously receives and consumes the
benefits provided by Tellev’s performance over this period as Tellev stands ready
during this period to provide repair or replacement services.
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Illustrative Example 10 (continued)
That is, on 1 October 20X0, Tellev recognises the following journal entry:
Debit Credit
HK$ HK$
Cash 3,500
Contract liability (warranty) 700
Revenue (handset) 2,800
Cumulatively over the period 1 October 20X2 to 30 June 20X3, Tellev records the
following journal entry to recognise revenue for the warranty service as the service
is rendered:
Debit Credit
HK$ HK$
Contract liability (warranty) 700
Revenue (warranty) 700
Applying Other HKFRS Applicable to the Transaction
In addition, throughout the period 1 October 20X0 to 30 September 20X2, Tellev
recognises a provision for warranties in accordance with HKAS 37 in an amount that
reflects its best estimate of its obligation to repair or replace the handset.
5.4.3 Customer Loyalty Programmes
A customer loyalty programme can take different forms, including the promise of a free good
or service if a certain number of goods or services are purchased (e.g. ‘get the 10th coffee free’
customer loyalty cards) and the option to acquire free goods or services as you accumulate
‘points’ with purchases (e.g. accrual of frequent flier miles with air flights travelled that can be
exchanged for goods).
A customer loyalty programme gives the customer the option to acquire additional goods
or services. Where the option gives customers a material right that they would not have
received if they had not entered into the related contract (e.g. the right to buy goods at a
discount to the stand-alone selling price of the good), the right is accordingly identified as a
HKFRS
separate performance obligation in the contract. In substance, this reflects that the customers
15.B40–B41 have prepaid for a future good or service.
In accordance with HKFRS 15, a portion of the transaction price must be allocated to that
future good. Recall that this allocation is based on the relative stand-alone selling prices of the
promised goods and services: In many cases, the stand-alone selling price of a customer’s
option to acquire additional goods and services will not be directly observable. In these
instances, HKFRS 15 requires the entity to estimate it, and the estimate must reflect any
additional discount the customer obtains when exercising the option (the estimate ignores any
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HKFRS portion that the customer could obtain without exercising the option) and the likelihood the
15.B42 option will be exercised.
In accordance with HKFRS 15, a contract liability relating to the future good or service is
recognised until such time as the good or service is transferred or the customer’s rights to
it expire. However, because not all customers may exercise all of their contractual rights, an
entity must consider ‘breakage’ in its estimate of the contract liability. An example of this is a
coffee card in which ‘every tenth cup of coffee is free’ promotion; a customer may never collect
a free cup of coffee because the customer either does not buy nine cups or never exercises
their right to the free cup. If an entity:
• Expects to be entitled to a breakage amount – the entity recognises the expected
breakage amount as revenue in proportion to the pattern of rights exercised by the
customer; and
• Does not expect to be entitled to a breakage amount – the entity recognises the
HKFRS expected breakage amount when the likelihood of the customer exercising its
15.B46 remaining rights becomes remote.
Illustrative Example 11 – Adapted from HKFRS 15, Illustrative Examples,
Example 52
CC Limited (CC) has a customer loyalty programme that rewards a customer with one
customer loyalty point for every HK$100 of purchase. Each point is redeemable for a
HK$1 discount on any future purchases of the entity’s products. During the reporting
period, customers purchase products for HK$10 million and earn 100,000 points
redeemable for future purchases.
The stand-alone selling price of the purchased products is HK$10 million. CC expects
90% of points earned to be redeemed and, at contract inception, estimates the points to
have a stand-alone selling price of HK$0.90 per point (totalling HK$90,000).
CC assesses the points provide a material right to customers that they would not
receive without entering into a contract and treats the option as a separate performance
obligation. Consequently, CC allocates the transaction price (HK$10 million) to the product
and the points on a relative stand-alone selling price basis as follows:
Product HK$9,910,803 [HK$10 million (HK$10 million ÷ HK$10,090,000)]
Points HK$89,197 [HK$10 million (HK$90,000 ÷ HK$10,090,000)]
At the end of the first reporting period, 40,000 points have been redeemed. CC
continues to expect 90,000 points to be redeemed in total. The entity recognises the
following journal entry to reflect the in-part satisfaction of the performance obligation:
Debit Credit
HK$’000 HK$’000
Contract liability 39,643
Revenue (40,000/90,000 HK$89,197) 39,643
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Illustrative Example 11 (continued)
At the end of the second reporting period, 85,000 points have been redeemed
cumulatively. CC now expects that cumulatively 92,000 points will be redeemed. The entity
recognises the following journal entry to reflect the in-part satisfaction of the performance
obligation:
Debit Credit
HK$’000 HK$’000
Contract liability 42,767
Revenue ((85,000/92,000 HK$89,197) − HK$39,643) 42,767
No points were redeemed during the third reporting period. At the end of the third
reporting period, CC determines that the likelihood that outstanding points will be
redeemed is remote and recognises the following journal entry:
Debit Credit
HK$’000 HK$’000
Contract liability 6,787
Revenue (HK$89,197 − HK$39,643 − HK$42,767) 6,787
The balance of the contract liability after processing this journal entry is nil, reflecting
the entity’s assessment that it has satisfied all its performance obligations relating to the
contracts.
5.4.4 Consignment Arrangements
In some industries, an entity may transfer goods to a counterparty, such as a dealer or a
distributor in a consignment arrangement. Recall that an entity recognises revenue when or as
it satisfies its performance obligation in a contract, being when the customer gains control of
the promised good or service: In a consignment arrangement, the dealer-customer does not
HKFRS obtain control of the goods even though it has received delivery of the goods. Hence, the entity
15.B77 cannot recognise revenue upon delivery of the goods to the consignee.
Indicators that an arrangement is a consignment arrangement include:
• The goods are controlled by the entity until a specified event occurs, such as the sale of
the product to a customer of the dealer or until a specified period expires;
• The entity is able to require the return of the goods or transfer the goods to a third
party, such as another dealer; and
HKFRS • The dealer does not have an unconditional obligation to pay for the goods although it
15.B78 might be required to pay a deposit.
An entity must consider all relevant facts and circumstances in determining whether the
contract is a consignment arrangement where which control of the good has not passed to the
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customer (i.e. in substance, the entity has not yet sold the good). An example of a consignment
arrangement is an art gallery that displays and sells artwork on behalf of an artist, earning a
commission on the items sold. Although the artwork is physically located at the gallery and
some risks of ownership of the items borne by the gallery (e.g. damage to the artwork resulting
from damage to the gallery), the gallery does not control the artwork as the gallery does not
have the ability to direct the use of, and obtain substantially all of the remaining benefits from,
the items. This is the conclusion drawn from an analysis of the indicators of control set out
in HKFRS 15:
• The entity has a present right to payment for the good or service – the gallery is entitled
to a commission for the service it performs in selling the artwork, but not payment for
the artwork itself.
• The customer has legal title to the good or service – the gallery does not have legal title
to consignment artwork; this remains with the artist-entity
• The entity has transferred physical possession of the good or service – physical
possession of the artwork is with the gallery; however, the artist-entity can require the
artwork be returned.
• The customer has the significant risks and rewards of ownership of the good or
service – the gallery is exposed to some risks of ownership; however, it is not exposed
to rewards from ownership as it only earns a commission on sale of the artwork.
HKFRS • The customer has accepted the good or service – the gallery accepts physical
15.38 possession of the artwork but does not accept rights to the artwork.
Accordingly, the artist cannot recognise revenue until such time as the artwork is sold by
the gallery to a customer.
5.4.5 Bill-and-hold Arrangements
A bill-and-hold arrangement is a contract under which an entity bills a customer for a good, but
the entity retains physical possession of the good until it is transferred to the customer at a
point in time in the future. For example, a customer may request an entity to enter into such a
HKFRS contract because of the customer’s lack of available space for the good or because of delays in
15.B79 the customer’s production schedules.
An example of a bill-and-hold arrangement is when a manufacturer buys inputs from its
supplier but asks its supplier to delay delivering the goods until a future specified date because
of a fire at the customer’s warehouses. Another example is when custom-built furniture is held
in the warehouse for an extended period until the customer is ready to receive it. Revenue
recognition in a bill-and-hold arrangement depends on when the good and any related services
are transferred to the customer, that is, when control of the good passes irrespective of the
good being physically located at the seller’s premises. An entity considers whether:
• Control of the good remains with it until a future point in time (e.g. on shipping to the
customer or receipt at the customer’s site); that is, the performance obligation is not yet
satisfied and no revenue is recognised; or
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• It has passed control of the good to the customer even though the good remains on
site. A customer cannot be said to have obtained control of a good in a bill-and-hold
arrangement unless the following features are also present:
° The reason for the bill-and-hold arrangement must be substantive (e.g. the
customer has requested the arrangement);
° The product must be identified separately as belonging to the customer;
° The product currently must be ready for physical transfer to the customer; and
HKFRS ° The entity cannot have the ability to use the product or to direct it to another
15.B80–81 customer.
An entity may continue to have an unsatisfied performance obligation relating to
the contract in a bill-and-hold arrangement where control of the product has passed to the
customer, for example, for custodial services relating to the product. In such cases, the
transaction price of the contract will need to be allocated to the satisfied and unsatisfied
HKFRS performance obligations, such that revenue recognition on the contract is not completed until
15.B82 the entity loses physical possession of the product.
A contract that includes a bill-and-hold arrangement may not be explicitly described in that
manner. Accordingly, an entity must critically evaluate the relevant facts and circumstances
of each contract to determine whether all distinct promised goods and services have been
identified and the point at which control of a good or services passes, regardless of whether the
item remains in the physical possession of the entity.
5.4.6 Principal vs Agent Considerations
When another party is involved in providing goods or services to a customer, an entity will need
to determine whether the nature of its promise is a performance obligation to:
• Provide the specified goods or services itself (i.e. the entity is a principal); or
HKFRS • Arrange for those goods or services to be provided by the other party (i.e. the entity is
15.B34 an agent).
As illustrated in Exhibit 5.15, an entity acts as a principal if it controls the specified good or
service before that good or service is transferred to a customer. An entity may be a principal
in relation to some goods and services in a contract and act as an agent for other items in
that contract.
Entity A sells Product A Entity B sells Product A
[principal] [principal or agent]
Entity A considers whether a customer Entity B considers whether it controls Product A before it is
has gained control of Product A ultimately held by customers.
(e.g. bill-and-hold, consignment • If yes, Entity B is acting as principal. Entity B recognises
arrangement). Entity A recognises product sales revenue.
revenue relating to Product A only • If no, Entity B is acting as an agent. Entity B recognises
when the customer (which is Entity B commission revenue.
where if Entity B is acting as principal)
has obtained control of Product A.
EXHIBIT 5.15 Principal vs Agent
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Indicators that an entity controls a specified good or service before it is transferred to the
customer include:
• The entity is primarily responsible for fulfilling the promise to provide the specified
good or service (e.g. the entity is responsible for delivering the product even if the entity
sub-contracts the job to another party);
• The entity has inventory risk before the specified good or service has been transferred
to a customer or after transfer of control to the customer (e.g. if the customer has a
right of return); and
HKFRS
15.B37 • The entity has discretion in establishing the price for the specified good or service.
Identifying whether an entity conducts a transaction as a principal or agent is important
for revenue recognition because misidentifying an entity that is an agent as a principal will
result in the entity’s reported revenues being overstated (amongst other implications for the
financial statements). For example, consider the art gallery example described in Section 5.4.4
and assume that the art gallery sells a customer a piece of artwork for HK$5 million, being the
price set by the artist plus the gallery’s premium. Under the terms of the agreement with the
artist, the gallery remits 80% of the amount received to the artist (HK$4 million) and retains
the balance as its share of the proceeds for services rendered for the artist. In this example,
the gallery concludes that it does not control the artwork and accordingly is acting as an
agent of the artist as (1) the artist is primarily responsible for fulfilling the promise to provide
the artwork, (2) the artist has set the price and (3) other facts and circumstances, such as the
gallery remitting the sale price less the gallery’s premium indicate that the gallery is providing
a service to the artist (e.g. providing a space to display the artwork and facilitating the sale)
rather than having control over the artwork. Accordingly, the gallery recognises revenue of
HK$1 million on the sale, being its commission on the sale comprising its compensation for
providing services to the artist. However, if the gallery erroneously concludes it is acting as a
principal in the transaction, it would recognise revenue of HK$5 million, thereby overstating its
reported revenue by HK$4 million. It would also have to derecognise the artwork asset from
its accounting records. Remember, to conclude that it is acting as a principal, the gallery must
first conclude that the gallery controls the artwork.
5.4.7 Licencing
In some contracts, an entity promises to transfer a licence that establishes a right to intellectual
property (IP) of the entity to the customer (e.g. sale of an off-the-shelf accounting package).
In other contracts, an entity may promise to grant the customer a licence in addition to other
promised goods or services, for example, a licence to use the Windows operating system and
promised upgrades. Licences of IP include licences over software and technology, film and
music and other forms of media and entertainment, franchises and patents, trademarks and
copyrights.
A promised licence may be a distinct good or service or may be indistinct from another
good or service promised in the contract. Recall Step 2 of the five-step model: Where the
promise to grant the licence is distinct from the other promised goods or services in a
contract, the promise to grant the licence is treated as a separate performance obligation.
Otherwise, it is bundled together with other goods or services into a single performance
obligation.
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FINANCIAL REPORTING
Examples of licences not distinct from other goods or services promised in the
contract include:
• A licence that forms a component of a tangible good and is integral to the functionality
of that good (e.g. included in the sale of a physical copy of the International Financial
Reporting Standards (IFRS) (Red Book) is a licence over the copyrighted text); and
• A licence that the customer can benefit from only in conjunction with a related service
(such as an online service provided by the entity that enables, by granting a licence, the
customer to access content). For example, included in the HKICPA membership is a
HKFRS licence over HKICPA-produced materials, provided through digital access to the
15.B54 HKICPA library.
We will now consider when revenue relating to licences, separate performance obligations
(i.e. distinct licences), is recognised and explain how the transaction price relating to a distinct
licence is determined.
5.4.7.1 Determining the Nature of the Entity’s Promise
The nature of the entity’s promise to grant a distinct licence is relevant to determining whether
that separate performance obligation is satisfied at a point in time or over time. The nature of
the entity’s promise to grant a licence is either to provide the customer with:
• A right to access the entity’s IP as it exists throughout the licence period; or
• A right to use the entity’s IP as it exists at the point in time at which the licence
is granted.
Exhibit 5.16 explains whether the entity has granted a licence to provide a right to access or
a right to use its IP and how the performance obligation is satisfied.
Contract Does the contract require,
Do the rights granted by
includes a or the customer reasonably Do those activities cause
the licence directly expose YES NO Promise to provide a
promise to grant expect, the entity to undertake YES a good or service to be
the customer to both positive
to the customer activities that significantly affect transferred to the customer right to access IP
and negative effects of those
a distinct licence the IP that is the subject of as those activities occur?
activities?
that establishes the licence?
a right to the
NO NO YES The performance
entity’s IP
obligation is satisfied
Promise to provide a over time
right to use IP
The performance
obligation is satisfied
at a point in time
EXHIBIT 5.16 Establishing the nature of the entity’s promise to grant a licence
An entity’s activities significantly affect the IP to which the customer has rights when the
activities are expected to significantly change the form or the functionality of the IP or the
HKFRS
ability of the customer to obtain benefit from the IP is substantially derived from, or dependent
15.B59A on, those activities.
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Apply and Analyse 6 – Adapted from HKFRS 15, Illustrative Examples,
Example 57
Hungry Gorilla, a fast food company, enters into a contract to grant a franchise licence to
customer Pei Sha. The licence gives the customer the right to use the ‘Hungry Gorilla’ trade
name and sell Hungry Gorilla products for five years. As part of Hungry Gorilla’s customary
business practices, it undertakes activities, such as analysing the consumers’ changing
preferences and implementing product improvements, pricing strategies, marketing
campaigns and operational efficiencies. The licence requires the customer to implement
any changes that result from those activities (e.g. introduce new food items).
Determine how Hungry Gorilla accounts for this contract.
Analysis
Applying Step 2 to Step 4 of the Five-Step Model
Hungry Gorilla must first identify the performance obligations in the contract. Hungry
Gorilla determines that it has a single performance obligation in this contract, being the
promise to transfer a licence. The additional activities associated with the licence (e.g.
development of new food items) are not performance obligations because they do not
directly transfer a good or service to the customer. Rather, they are part of the licence.
Accordingly, Hungry Gorilla attributes the entire transaction price of the contract to the
promise to transfer a licence.
Applying Step 5 of the Five-Step Model
Hungry Gorilla next assesses the nature of its promise to grant the licence to determine
whether the related revenue is recognised at a point in time or over time. It assesses that:
• The ability of the customer to obtain benefit from the IP is substantially derived
from, or dependent on, the expected activities of Hungry Gorilla. This is on the
basis of Hungry Gorilla’s customary business practices to undertake activities
that protect, promote or improve the franchise name and products. Accordingly,
Hungry Gorilla concludes the customer would reasonably expect Hungry Gorilla
to undertake activities that will significantly affect the IP that is the subject of the
licence; and
• The rights granted by the licence directly expose the customer to positive and
negative effects of Hungry Gorilla’s activities because the licence requires the
customer to implement any changes that result from those activities; and
• Even though the customer may benefit from those activities through the rights
granted by the licence, the rights do not transfer a further good or service to the
customer as those activities occur.
Consequently, Hungry Gorilla concludes that the nature of its promise in transferring
the licence is to provide the customer with a right to access its IP throughout the licence
period; that is, the performance obligation is satisfied over time. Hence, in accordance with
HKFRS 15, Hungry Gorilla recognises revenue on the contract over time (in this case, the
five-year term of the licence).
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5.4.7.2 Sales-based or Usage-based Royalties
Consideration in the form of a sales-based or usage-based royalty is ordinarily accounted for
in a similar manner to other variable consideration in estimating the transaction price of a
contract with a customer (see Section 5.2.3.1). However, an exception from the constraints that
would ordinarily limit the amount of variable consideration included in the transaction price
applies to a sales-based or usage-based royalty:
• Where the royalty has been promised in exchange for a licence of IP; or
• When a licence of IPis the predominant item to which the royalty relates (e.g. when the
HKFRS
15.B63, entity has a reasonable expectation that the customer would ascribe significantly more
B63A value to the licence than to the other goods or services also subject to that royalty)
Rather than applying the constraints that would ordinarily limit the amount of variable
consideration included in the transaction price, HKFRS 15 specifies that an entity recognises
revenue for a sales-based or usage-based royalty promised in exchange for a licence of IP only
when (or as) the later of the following events occurs:
• The subsequent sale or usage occurs; and
• The performance obligation to which some or all of the sales-based or usage-based
royalty has been allocated has been satisfied (or partially satisfied).
Illustrative Example 12
(The following example is a continuation of Apply and Analyse 11)
In exchange for granting the franchise licence, Hungry Gorilla will receive consideration
in the form of a sales-based royalty of 5% of the customer’s (the franchisee) monthly sales.
In accordance with HKFRS 15, Hungry Gorilla recognises revenue for the licence over the
five-year franchise period.
Hungry Gorilla determines that an appropriate method of measuring its progress
towards satisfaction of the performance obligation is based on the actual monthly sales
because the amount of its right to consideration corresponds directly with the value to
the customer of the entity’s performance completed to date. Hence, in this example, the
timing of the sale giving rise to the royalty and the partial satisfaction of the performance
obligation is the same.
5.4.8 Repurchase Agreements
A repurchase agreement is a contract in which an entity sells an asset and also promises or has
the option (either in the same contract or in another contract) to repurchase the asset. The
repurchased asset may be the asset that was originally sold to the customer, an asset that is
HKFRS substantially the same as that asset or another asset of which the asset that was originally sold
15.B64 is a component. In such instances, the objective of the transaction may not be, in substance, to
sell the asset to the customer; hence, all relevant facts and circumstances must be considered
in accounting for a transaction. For example, the objective may instead be to address
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HKFRS short-term liquidity needs or to misrepresent the performance of the entity. Repurchase
15.B65 agreements are generally in the form of a forward, a call option or a put option. Whether or not
a repurchase agreement is treated as a sale of an asset resulting in the recognition of revenue
depends on the type of derivative financial instrument issued and the facts and circumstances
of the contract. This ensures the accounting for the agreement reflects the substance, rather
than the form, of the transaction.
Exhibit 5.17 summarises the accounting treatment when an entity enters into a contract
with a customer that includes the transfer of a forward (obligation for the entity to repurchase
HKFRS asset), call option (option for the entity to repurchase asset) or put option (obligation for entity
15.B66–B76 to repurchase asset) to the customer.
Entity transfers . . . Forward or call option Put option
Control of asset No because the customer is Dependent on whether there is no
transferred limited in its ability to direct the significant economic incentive to the
use of, and obtain substantially customer to put the asset back to the
all of the remaining benefits entity. Revenue will be recognised
from, the asset even though the when the asset is transferred to the
customer may have physical customer in some cases.
possession of the asset. Revenue
is not recognised when the asset
is transferred to the customer.
Repurchase price < Leasing arrangement Lease arrangement – if customer
sale price has significant economic incentive to
exercise the put
Sale with a right of return – if customer
does not have a significant economic
incentive to exercise the put
Repurchase price ≥ Financing arrangement (asset is Financing arrangement – if repurchase
sale price not derecognised and a financial price is also more than expected
liability is recognised) market value of the asset
Sale with a right of return – if
repurchase price is equal or less than
expected market value of the asset
and the customer does not have a
significant economic incentive to
exercise the put
EXHIBIT 5.17 Treatment of repurchase agreements
HKFRS Where a call option or put option lapses unexercised, the financial liability is derecognised
15.B69, B76 and revenue recognised.
5.4.9 Loss-making Contracts
Some contracts with customers are loss-making in that the contract costs are expected to
exceed contract revenues. A contract may be loss-making when it is entered into, or it may
become loss-making at some point during its term. In some cases, an entity may have a
commercial objective in entering into a contract that it knows is going to be a loss-leader;
it expects the transaction to generate future economic benefits in the form of additional
revenues from other contracts. An example of this is a better-than-cost promotional sale that
introduces a product to potential return customers.
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Where a contract is loss-making, an entity:
• Continues to recognise revenue when (or as) performance obligations are satisfied in
accordance with the accounting specified by HKFRS 15;
• Considers whether any capitalised contract costs need to be impaired (see
Section 5.3.3);
• Considers whether any receivable related to the contract needs to be impaired in
accordance with HKFRS 9 (see Chapter 12); and
• Considers whether a provision for an onerous contract needs to be recognised
in accordance with HKAS 37 Provisions, Contingent Liabilities and Contingent Assets
(see Chapter 18).
The latter three bullet points are reflected as expenses in profit or loss and not as a
reduction of revenue.
5.4.10 Long-term Construction Contracts
A ‘construction contract’ commonly refers to a contract specifically negotiated for the
construction of an asset or a combination of assets closely interrelated or interdependent in
terms of their design, technology and function or their ultimate purpose or use, for example,
the construction of a building or real estate complex or development of software. Prior to the
issue of HKFRS 15, construction contracts were accounted for using different rules to those
applying to other contracts with customers.
One of the reasons for issuing HKFRS 15 was to address the diversity in previous revenue
recognition practices. Consequently, HKFRS 15 was developed as a principles-based framework
applying across all industries to all contracts with customers except where a specific other
HKFRS applies, for example, HKFRS 9 Financial Instruments. Accordingly, for example, an
entity operating in the construction and property industry now applies the same approach to
recognising revenue arising from its contracts with customers as would an entity operating in
the transportation industry or in entertainment and media.
Among other matters, an entity entering into a construction contract must consider:
• Whether any costs incurred, for example, bidding costs, meet the criteria to be
recognised as capitalised costs to obtain or costs to fulfil a contract in accordance with
HKFRS 15 or another HKFRS;
• Whether there is only a single performance obligation in the contract, for example,
whether the entity has promised to deliver a finished building;
• Whether revenue is recognised progressively over the construction build or at a point
in time; in practice, many construction contracts are likely to be structured in a manner
where which the performance obligation(s) in the contract are said to be satisfied
over time;
• How it should measure its progress towards completion of the contract;
• What amount to include as its estimate of the transaction price and, accordingly,
recognise as revenue when the contract includes variable consideration (e.g. incentive
bonuses and penalties);
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• The impact of any contract modification on the accounting for the contract; in practice,
a modification to the original construction contract is common; and
• Whether contract costs are expected to exceed contract revenues, and if so, whether an
onerous contract provision needs to be recognised.
The following example illustrates the effect on reported revenue over the contract duration
for a construction contract whose performance obligations are satisfied over time.
Illustrative Example 13 – Adapted from HKFRS 15 Illustrative Examples,
Example 17
On 1 January 20X3, Archer Limited (Archer) enters into a contract with customer Beacon
Limited (Beacon) to construct a building on Beacon’s land for HK$7 million. Under
the terms of the contract, Beacon pays a non-refundable deposit of HK$100,000 on
contract inception and makes progress payments on the balance on achievement of
agreed construction milestones during the construction. In addition, if Archer completes
construction on or before the agreed completion date of 31 December 20X5, Beacon
agrees to pay Archer a performance bonus of HK$1 million.
The contract includes substantive terms that do not allow Archer to direct the
building to another customer. The contract is non-cancellable except in instances of
non-performance by the other party. If Beacon fails to make its payments under the
contract when due, Archer has the right to all of the consideration promised in the contract
if it completes construction of the building.
Archer has limited experience in projects of this size. Also, Archer’s experience to date
is that it completes its projects up to two weeks after the specified date due to weather
conditions and labour availability.
Archer expects the total costs of constructing Beacon’s unit will be HK$4 million.
Assume that the costs meet the criteria to be recognised as assets.
At Contract Inception
Applying Step 2 of the five-step model
Archer determines it has one performance obligation under its contract with Beacon,
being its promise to construct and transfer a specified building. This is because Archer
will be providing a significant service of integrating the goods and services to produce
the constructed building.
Applying Step 3 and Step 4 of the five-step model
Archer estimates the transaction price of the contract to be HK$7 million at contract
inception, which it allocates to its promise to construct and transfer a specified building.
The performance bonus is excluded from the transaction price as Archer cannot
determine that it is highly probable a significant reversal in the cumulative amount of
revenue recognised will not occur. Archer makes this determination having regard to its
lack of experience with projects this size and its history of completing projects after the
specified date.
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Illustrative Example 13 (continued)
Applying Step 5 of the five-step model
Archer next considers whether the performance obligation is satisfied over time or at a
point in time. Archer observes that:
• Beacon does not simultaneously receive and consume the benefits provided by
Archer’s performance as Archer performs under the contract because the contract
is for the sale of a good;
• Archer’s performance creates or enhances an asset the customer controls
as the asset is created or enhanced because the asset is constructed on
customer-owned land; and
• The building created by Archer’s performance (construction) does not have an
alternative use to Archer as the entity is unable to transfer it to another customer, and
Archer has a right to payment for performance completed to date because it has an
enforceable right to all of the consideration promised under the contract in the event
of Beacon defaulting so long as Archer continues to perform under the contract.
Accordingly, Archer concludes that the performance obligation meets the criteria
specified by HKFRS 15 for a performance obligation satisfied over time. Archer determines
it would be appropriate for progress on this contract to be measured using a ‘basis of costs
incurred’ approach because it considers this faithfully depicts the entity’s performance in
transferring control of the unit to Beacon.
On 1 January 20X3, no construction activity has commenced, however as Archer has
received a non-refundable deposit for the building, Archer will need to record the following
journal entry:
Debit Credit
HK$ HK$
DR Cash 100,000
Contract liability 100,000
Reporting date 31 December 20X3
By 31 December 20X3, Archer has incurred costs of HK$200,000. Also, the first progress
payment under the contract of HK$1 million is now due. Archer re-evaluates its estimates
of variable consideration and costs, and determines its contract inception date estimates
are still appropriate.
Archer records the following journal entry to recognise its progress on the project:
Debit Credit
HK$ HK$
Receivable 1,000,000
Contract liability 650,000
Revenue 350,000
($200,000/$4 million $7 million)
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Illustrative Example 13 (continued)
Reporting date 31 December 20X4
By 31 December 20X4, Archer has incurred further costs of HK$2.8 million. During the
year, Archer has also invoiced for two further progress payments under the contract
totalling HK$4 million. In addition, at 31 December 20X4 Archer re-evaluates its estimate
of variable consideration as required by HKFRS 15, and now assesses that a significant
reversal in the cumulative amount of revenue recognised would probably not occur if the
performance bonus were included in the transaction price.
Archer records the following total journal entry during the year to recognise its
progress on the project:
Debit Credit
HK$ HK$
Accounts receivable 4,000,000
Contract asset 900,000
Contract liability 750,000
Revenue 5,650,000
($2.8/$4 million $8 million $200,000/$4 million $1 million)
Reporting date 31 December 20X5
Archer transferred the building to Beacon on 8 December 20X5. As the building was
transferred ahead of schedule, Beacon was entitled to the performance bonus.
Archer records the following total journal entry during the year to recognise its
progress on the project and the contract completion:
Debit Credit
HK$ HK$
Receivable 2,900,000
Contract asset 900,000
Revenue 2,000,000
($8 million less $6 million previously recognised)
Knowledge Check Questions
Question 14
Identify which one of the following statements is true in relation to a sale with a right
of return.
A An entity must recognise a refund liability for the entire amount of consideration
received that is subject to a right of return.
B An entity does not recognise revenue on transferring goods subject to a right of return
until the right expires.
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Knowledge Check Questions (continued)
C The asset representing an entity’s right to recover products on settling a refund liability
is measured at the pre-sale carrying amount of the good in the entity’s books, less any
expected costs of recovery.
D An entity’s assessment of the extent to which goods will be returned is made at contract
inception and is not updated until the right of return expires.
Question 15
TravelCo Limited (TravelCo) is a travel agent. It enters into a contract with customer Qin
to issue airline tickets to New York for HK$12,000 on behalf of the airline carrier. TravelCo
collects the full amount of the ticket price from Qin and passes on 95% of the amount to
the airline carrier.
Calculate the amount of revenue that TravelCo recognises relating to the contract with
Qin. Justify your response.
Question 16
Identity which, if any, of the following statements is true. Select all that apply.
A An entity recognises revenue for a store warranty when it is sold. A provision for
warranty claims is recognised at the same time.
B An entity controls a product when the product is in the entity’s physical possession.
C The entity continues to control a product transferred to a customer in all instances
where the transaction includes a financial instrument to repurchase a product from
the customer.
D The likelihood of customers exercising their option to goods offered under a customer
loyalty programme is taken into account in estimating the transaction price of
a contract.
Question 17
Identify which of the following is not true of a grant of a licence to a customer.
A The entity must identify whether the licence is a distinct good.
B The entity must determine whether the licence gives the customer a right to use the
intellectual property (IP) under licence, or a right to access the IP under licence.
C Where the promised consideration is in the form of a royalty, the entity must estimate
the minimum royalty amount it expects to be entitled to and recognises this as revenue
over the licence term. The entity recognises a true-up at the end of the licence term so all
royalties received are eventually recognised as revenue.
D The entity has promised to provide a right to access IP in instances where the
customer can reasonably expect the entity to undertake activities that change the IP
under licence.
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5 . 5 PRESENTATION AND DISCLOSURE
The purpose of a general purpose financial report is to communicate financial information
about an entity that is useful to its existing and potential investors, lenders and other creditors
in making decisions about providing resources to the entity. These users need information
about the economic resources of the entity, claims against the entity and changes in those
resources and claims. They also need information about how efficiently and effectively the
entity’s management and governing board have discharged their responsibilities to use the
entity’s resources.
To be useful, the financial information included in the general purpose financial report
needs to be relevant and faithfully represent what it purports to represent. Accordingly, an
entity’s disclosures about its contracts with customers should be entity-specific, relating to its
products and reflecting the way the entity operates. The entity explains its revenue recognition
policies and the impact of those policies on the entity’s financial position and financial
performance.
Because a disclosure is entity-specific, different entities may emphasise different aspects of
the specified disclosures, aggregate or disaggregate to different levels of detail or in different
ways, use different descriptions, use different presentation methods or make more extensive
or fewer disclosures. However, an entity’s disclosures will ultimately need to be sufficient to
meet the following disclosure objective:
The objective of the disclosure requirements is for an entity to disclose sufficient information to
enable users of its financial statements to understand the nature, amount, timing and uncertainty
of revenue and cash flows arising from its contracts with customers.
To achieve the disclosure objective, HKFRS 15 requires an entity to disclose qualitative and
quantitative information about its:
• Contracts with customers;
• The significant judgements made in relation to its contracts with customers, and
changes in those judgements; and
• Assets recognised from the costs to obtain or fulfil a contract with a customer.
Some of the disclosures specified by HKFRS 15 may also be specified by another HKFRS
(e.g. HKFRS 9 Financial Instruments or HKAS 1 Presentation of Financial Statements). There is no
need to present the same disclosure twice.
5.5.1 Contracts with Customers
An entity discloses the following amounts for the reporting period:
• Revenue recognised from contracts with customers, separately from other sources
of revenue.
HKFRS • Impairment losses (in accordance with HKFRS 9 Financial Instruments) on receivables
15.113 and contract assets arising from contracts with customers.
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(These disclosures are specified by HKFRS 15 to provide context for other specified
disclosures.)
In addition, HKFRS 15 requires an entity to disclose the following information about its
contract with customers:
• Information about the disaggregation of revenue (see Section 5.5.1.1).
• Information about contract balances (see Section 5.5.1.2).
• Information about the entity’s performance obligations under its contracts
(see Section 5.5.1.3).
• Information about the transaction price allocated to outstanding performance
obligations (see Section 5.5.1.4).
5.5.1.1 Disaggregation of Revenue
To help users of the financial statements understand the composition of the revenue from
contracts with customers recognised in the current period, HKFRS 15 requires an entity
to disclose:
• Revenue recognised from contracts with customers disaggregated into categories that
depict how the nature, amount, timing and uncertainty of revenue and cash flows are
affected by economic factors; and
HKFRS • Sufficient information to enable users of financial statements to understand the
15.114–115
relationship between disaggregated revenue and any operating segment revenue
HKFRS
15.BC335 information that has been disclosed in accordance with HKFRS 8 Operating Segments.
Examples of possible categories include the type of good or service, geographical region,
HKFRS market or customer type, contract type, contract duration, timing of transfer of goods or
15.B89 services and sales channels. Exhibit 5.18 illustrates an example of these disclosures. An entity
may present the required information in a different manner; for example, it may be difficult to
show the relationship between disaggregated revenue and segment revenue in this manner
due to differences in the manner operating segment revenue is determined.
A user must be able to
understand the relationship
Segments Consumer products Transport Energy Total between the disaggregated
CU CU CU CU revenue disclosures and
An entity must Primary geographical markets
North America 990 2,250 5,250 8,480 operating segment revenue.
disclose a relevant Europe 300 750 1,000 2,050 (Note: HKFRS 15 does not
disaggregation of Asia 700 260 – 960 require an entity to present
revenue. 1,990 3,260 6,250 11,500 this information only in the
Major goods/service lines manner illustrated.)
Office supplies 600 – – 600
If may be Appliances 990 – – 990
appropriate Clothing 400 – – 400
Total revenue form
to show more Motorcycles – 500 – 500
Automobiles – 2,760 – 2,760 contracts with customers
than one form Solar panels – – 1,000 1,000 would normally match
of disaggregated Power plant – – 5,250 5,250
revenue as presented on
revenue 1,990 3,260 6,250 11,500
the face of the statement
(e.g. if routinely Timing of revenue recognition of profit or loss.
reported in all Goods transferred at a point in 1,990 3,260 1,000 6,250
time
these ways). Services transferred over time – – 5,250 5,250
1,990 3,260 6,250 11,500
EXHIBIT 5.18 Illustration of the HKFRS 15 requirement to disclose information to help users to
understand the composition of revenue (Source: HKFRS 15 Illustrative Examples, Example 41.)
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When selecting the type of category or categories to use to disaggregate revenue, an entity
considers how information about the entity’s revenue has been presented for other purposes,
including all of the following:
• Disclosures presented outside the financial statements (e.g. in earnings releases,
annual reports or investor presentations).
• Information regularly reviewed by the Chief Operating Decision Maker (e.g. the board
of directors or the CEO) for evaluating the financial performance of operating
segments.
• Other similar disclosures or information that is used by the entity or users of its
HKFRS financial statements to evaluate the entity’s financial performance or make resource
15.B88 allocation decisions.
5.5.1.2 Contract Balances
The purpose of the disclosures about an entity’s contract balances is to explain the relationship
between the amount of revenue recognised in a reporting period and the changes in the
entity’s contract assets and contract liabilities. These disclosures provide users of the financial
statements with information useful to assessing the nature, amount, timing and uncertainty of
revenue and cash flows arising from an entity’s contracts with customers. For example,
disclosure of the amount of revenue recognised in the reporting period relating to performance
obligations satisfied or partially satisfied in previous periods provides relevant information to
users about the timing of revenue recognition that was not a result of performance in the
HKFRS
15.BC341, current period and, therefore, useful information to understanding the current period
BC347 operating results and on predicting future revenue levels.
Exhibit 5.19 summarises the information an entity must disclose about its contract balances.
Disclosure specified by Possible location of the information
HKFRS 15.116–118
Opening and closing balances of Face of the statement of financial position
receivables from contracts with customers In the notes to the financial statements as a disaggregation
of the receivables amount disclosed on the face of the
statement of financial position (which could relate to trade
and non-trade receivables)
Opening and closing balances of Face of the statement of financial position
contract assets
Opening and closing balances of contract Face of the statement of financial position
liabilities
Revenue recognised in the reporting In the notes to the financial statements, possibly together
period that was included in the opening with information:
contract liability • about the composition of revenue (see Section 5.5.1.1)
• explaining the significant changes in the contract
liability balance
EXHIBIT 5.19 Specified disclosures about contract balances
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FINANCIAL REPORTING
Disclosure specified by Possible location of the information
HKFRS 15.116–118
Revenue recognised in the reporting In the notes to the financial statements, possibly together
period from performance obligations with information:
satisfied or partially satisfied in • about the composition of revenue (see Section 5.5.1.1)
previous periods • explaining the significant changes in the contract
liability balance
An explanation of how the timing of In the notes to the financial statements, possibly:
satisfaction of performance obligations • as part of the disclosures about the entity’s revenue
relates to the typical timing of payment recognition accounting policies
and the effect that those factors have • as part of a separate note discussion covering revenue,
on the contract asset and the contract the contract asset or contract liability
liability balances • together with liquidity disclosures specified by
HKFRS 7 Financial Instruments: Disclosures (contract
assets only)
A qualitative and quantitative explanation In the notes to the financial statements, possibly as part of
of the significant changes in the contract a separate note discussion covering revenue, the contract
asset and the contract liability balances asset or contract liability
during the reporting period
EXHIBIT 5.19 (Continued)
Changes in an entity’s balances of contract assets and contract liabilities could result from:
• Changes due to business combinations;
• Cumulative catch-up adjustments to revenue that affect the corresponding contract
asset or contract liability, including adjustments arising from a change in the measure
of progress, a change in an estimate of the transaction price (including any changes in
the assessment of whether an estimate of variable consideration is constrained) or a
contract modification;
• Impairment of a contract asset;
• A change in the time frame for a right to consideration to become unconditional, that is,
for a contract asset to be reclassified to a receivable; and
HKFRS • A change in the time frame for a performance obligation to be satisfied, that is, for the
15.118 recognition of revenue arising from a contract liability.
HKFRS 15 does not require entities to all present disclosures about contract balances in
the same manner. As such, an entity will need to consider how best to present information
about its contract balances in its financial report. For example, some entities may present a
reconciliation between the opening and closing contract liabilities balance; others may elect
to communicate similar information in a different form. Exhibit 5.20 illustrates an example
of these disclosuresL the form, location and extent of disclosures will vary from entity
to entity.
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Note X: Contract balances 20X1 20X0
HK$’000 HK$’000
Contract assets (i) 1,020 1,080
Explain how timing of Contract liabilities (ii), (iii) 8,000 6,100
satisfaction of performance
obligations relates to typical (i) The balance of contract assets mainly comprises amounts not yet billable on
the sale of apartment units. where application of the cost-to-cost method for Give a qualitative and
timing of payment and recognising revenue exceeds the amount currently billable to the customer. quantitative explanation
the effect those factors (ii) Payments received in advance of the company performing under the contract. of significant changes in
have on the contract The increase in contract liabilities from the prior year is primarily due to: the contract balances
asset/contract liability • The additional projects in progress arising from the acquisition of
Timber Limited (HK$1.5 million)
• Granite now expects to be entitled to bonus payments relating to several
projects in progress. Revenue for the year includes HK$0.5 million relating
to this change for performance completed in previous periods. Disclose revenue
Disclose revenue recognised (iii) HK$6 million of the opening contract liability was recognised as revenue in the recognised in the
in the current period current financial year (20X0: HK$7 million). The company expects to recognise
current period relating
included in the opening HK$7.6 million of the current contract liability balance in 20X2.
to previous performance
contract liability
Explain how the timing of satisfaction of
performance obligations relates to the typical
timing of payment and the effect those factors
have on the contract asset/contract liability
EXHIBIT 5.20 Illustration of the HKFRS 15 requirement to disclose information about contract
balances
5.5.1.3 Performance Obligations
The disclosures about an entity’s performance obligations in its contracts with customers
provide users with more context to understanding the entity’s revenues because the entity is
required to relate its revenue accounting policies to its contracts with customers. With respect
to its performance obligations in contracts with customers, HKFRS 15 requires an entity
to disclose:
• When the entity typically satisfies its performance obligations;
• The significant payment terms;
• The nature of the goods or services the entity has promised to transfer, highlighting any
performance obligations to arrange for another party to transfer goods or services, that
is, if the entity is acting as an agent;
• Obligations for returns, refunds and other similar obligations; and
HKFRS
15.119 • Types of warranties and related obligations.
For example, Tellev may disclose the following information to satisfy, in part, the
requirement to provide information about the nature of goods or services it has promised to
transfer and when it typically would satisfy performance obligations in those contracts:
Telecommunication Services
Revenue from mobile and landline calls is recognised on completion of the call. Revenue
from unlimited data services packages is recognised on a straight-line basis over the
period of service. Revenue from capped data services packages is recognised as data is
consumed during the period of service.
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5.5.1.4 Transaction Price Allocated to the Remaining Performance Obligations
An entity discloses the aggregate amount of the transaction price allocated to the unsatisfied or
partially unsatisfied performance obligations at the end of the reporting period and an
HKFRS explanation of when it will be recognised as revenue; this explanation may be provided
15.120 qualitatively or on a quantitative basis using appropriate time bands. This disclosure applies
HKFRS also to wholly unperformed contracts. In addition, the entity must explain qualitatively whether
15.BC51
any consideration from its contracts with customers has not been included in the transaction
price, for example, because it is subject to the variable consideration constraint, and is,
therefore, not included in the disclosure of the aggregate amount of the transaction price
HKFRS allocated to the unsatisfied or partially unsatisfied performance obligations at the end of the
15.122 reporting period.
An entity need not disclose this information if the performance obligation is part of a
contract that has an original expected duration of one year or less or if the entity recognises
revenue in an amount that corresponds directly with the value to the customer of the entity’s
HKFRS
15.121 performance completed to date, for example, entity bills a fixed amount for each unit of
HKFRS electricity consumed. An entity that does not disclose this information because it has taken
15.122 advantage of the practical expedient must disclose that fact.
Illustrative Example 14 – Adapted from IFRS 15 Illustrative Examples,
Example 43
Granite Limited (Granite) enters into a contract with customer Silicon Limited (Silicon)
to construct an office building by 31 December 20X2, which it has identified as being a
single performance obligation that it satisfies over time. The promised consideration is
HK$12 million, and at 30 June 20X1, Granite has recognised HK$4 million of that amount
as revenue. Granite estimates the construction projects will possibly take two months
longer to complete than planned due to poor weather conditions.
Granite might prepare the following note disclosure in its financial statements to
disclose the aggregate amount of the transaction price allocated to the partially unsatisfied
performance obligation at the end of the reporting period and an explanation of when it
will be recognised as revenue:
‘At 30 June 20X1, the aggregate amount of the transaction price allocated to the
remaining performance obligation is HK$8 million. Granite will recognise the revenue as
the building is completed, which is expected to occur over the next 18–20 months’.
5.5.2 Significant Judgements in the Application of this Standard
HKAS 1 Presentation of Financial Statements requires an entity to disclose its material accounting
policy information, judgements and sources of estimation uncertainty.
Because of the importance of understanding ‘revenue’ to a user’s decision making,
HKFRS 15 specifically requires an entity to disclose the judgements that significantly affect
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the determination of the amount and timing of revenue from contracts with customers,
and changes in those judgements. These disclosures must include the judgements, and
any changes in those judgements, used in the determining (1) the timing of satisfaction of
performance obligations and (2) the transaction price and amounts allocated to performance
obligations.
To provide users with an understanding of the timing of revenue recognition, an entity
discloses:
• With respect to performance obligations satisfied over time, the methods it uses to
recognise revenue and an explanation of why the selected method provides a faithful
depiction of the transfer of goods or services; and
• With respect to performance obligations satisfied at a point in time, the significant
HKFRS judgements made in determining when a customer obtains control of the good
15.124–125 or service.
To provide users with an understanding of the amounts of revenue recognised, an entity
discloses information about the methods, inputs and assumptions used for:
• Determining the transaction price (including estimating variable consideration,
adjusting the consideration for the effects of the time value of money and measuring
non-cash consideration);
• Assessing whether an estimate of variable consideration is constrained;
• Allocating the transaction price, including estimating stand-alone selling prices of
promised goods or services and allocating discounts and variable consideration to a
specific part of the contract; and
HKFRS
15.126 • Measuring its obligations for returns, refunds and other similar obligations.
HKFRS In addition, an entity adopting a practical expedient relating to the non-adjustment of
15.129 consideration for the time value of money must disclose that fact.
Apply and Analyse 7
Tellev is proposing to make the following note disclosure in the notes to its financial
statements: ‘Where two or more deliverables are sold under a single contract, each
deliverable is accounted for as a separate unit of account. Consideration on the contract
is allocated to each deliverable based on the relative standalone selling prices. The
consideration is limited to the amount that is not contingent upon the delivery of
additional items or meeting other specified performance obligations’.
Evaluate whether Tellev has disclosed information about its judgements that
significantly affect the determination of the amount and timing of revenue from contracts
with customers that is sufficient to meet the disclosure objective of HKFRS 15.
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Apply and Analyse 7 (continued)
Analysis
Tellev has not disclosed information about its judgements that significantly affect the
determination of the amount and timing of its revenue that is sufficient to enable users
of its financial statements to understand the nature, amount, timing and uncertainty of
revenue and cash flows arising from its contracts with customers. This is because:
• The disclosure that consideration on the contract is allocated to each deliverable
based on the relative stand-alone selling prices and it is constrained to
non-contingent consideration that is generic and non-specific to Tellev and,
accordingly, does not provide the user with an understanding of the judgements
Tellev uses to determine the transaction price of its contracts with customers;
• The disclosure tells users that variable consideration is constrained, but it does not
explain how Tellev has determined it should exclude contingent consideration from
its estimate of variable consideration; and
• The disclosure tells the user the allocation is based on stand-alone selling prices
but does not explain how Tellev determines the stand-alone selling prices.
5.5.3 Assets Recognised from the Costs to Obtain or Fulfil a Contract
with a Customer
In addition to disclosures about the contracts with customers and the significant judgements an
entity makes relating to those contracts, HKFRS 15 requires information to be disclosed about
any capitalised contract costs. These disclosures help users to understand the types of costs
recognised as assets and how those assets are subsequently amortised or impaired.
With respect to capitalised contract costs, an entity discloses:
• The judgements made in determining the amount of the costs incurred to obtain or
fulfil a contract with a customer;
• The method it uses to determine the amortisation for each reporting period;
• The closing balances of assets recognised from the costs incurred to obtain or fulfil a
contract with a customer, by main category of asset (e.g. costs to obtain contracts with
customers, pre-contract costs and setup costs); and
HKFRS • The amount of amortisation and any impairment losses recognised in the
15.127–128 reporting period.
HKFRS In addition, an entity adopting a practical expedient relating to the immediate expensing of
15.129 incremental costs of obtaining a contract must disclose that fact.
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SUMMARY
• HKFRS 15 specifies the accounting for revenue arising from contracts with customers and
related costs.
• Under HKFRS 15, revenue is recognised when (or as) an entity satisfies a performance
obligation by transferring a promised good or service to a customer. Revenue is measured at
the amount of consideration the entity expects to be entitled to in exchange for transferring
the good or service.
• Each good or service transferred to the customer in the contract has value and, accordingly,
an allocation of the transaction price must be attributed to that good or service.
• The five-step model requires the transaction price of a contract to be allocated to all the
performance obligations in the contract.
• The transaction price is updated at the end of each reporting period as the entity reassesses
its estimate of any variable consideration in the contract.
• A performance obligation may be satisfied over time or at a point in time.
• An entity measures its progress against satisfaction of a performance obligation satisfied
over time using an input method or output method that depicts the entity’s performance in
transferring control of the good or service.
• Certain costs of obtaining a contract or of fulfilling a contract must be capitalised and
amortised to profit or loss in a manner consistent with the transfer of the related promised
goods or services. Capitalised contract costs are subject to impairment requirements.
• An entity discloses sufficient information to enable users of its financial statements to
understand the nature, amount, timing and uncertainty of revenue and cash flows arising
from its contracts with customers.
• An entity discloses entity-specific information about its contracts with customers, the
significant judgements it makes in relation to those contracts, and information about contract
costs capitalised as assets.
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MIND MAP
SCOPE UNIT OF ACCOUNT
Inclusions Single contract or combined contract
• Contracts with a customer Practical expedients: Portfolio of contracts of
• Gains and losses on non-financial asset disposals performance obligations
Exclusions Contract modification: treat as separate contract,
• Leases, insurance contracts, financial instruments new contract or adjustment of existing contract
• Contractual right and obligations within scope of
HKFRS 10, HKFRS 11, HKAS 27, HKAS 28 TRANSACTION PRICE
• Non-monetary exchanges to facilitate sales
The amount of consideration the entity expects
DISCLOSURE to be entitled to
Entity-specific Changes as expectations of the amount of variable
Information to understand performance: revenue, and non-monetary consideration changes
contract balances, performance obligations, Reduced by consideration payable to the customer
significant judgements Reduced or increased by any significant financing
Information about contract costs element (HKFRS 9 interest)
CONTRACT COSTS REVENUE Constraints on transaction price
(HKFRS 15) (variable consideration)
Capitalise qualifying (1) costs of obtaining the
contract (2) costs to fulfill the contract Transaction price allocated to the
Option to immediately expense incremental performance obligations using relative
costs to obtain the contract if amoritisation stand-alone selling prices
period is one year or less
PERFORMANCE OBLIGATION
Capitalised costs amoritised on same Identify all promises to transfer a distinct good
basis as related performance obligations or service
Distinct: separately benefit and separately
RECOGNITION identifiable
Contract must be approved, rights and payment terms Implicit or explicit in a contract
known, have commercial substance, and collection of
consideration is probable Allocated transaction price recognised as revenue
Statement of financial position when (or as) the performance obligation is satisfied
• Contract liabilities, contract assets, capitalised contract costs (i.e. when control of good or service transferred)
• Refund liability
• Receivables (HKFRS 9)
Recognition in profit or loss: revenue and amoritisation
of capitalised contract costs
• Timing: over time or at a point in time
• Input or output methods to reflect progress over time
• Changes in transaction price or progress against satisfaction
of performance obligation: reflected as change in estimate
• Impair capitalised contract costs where not recoverable
Answers to Knowledge Check
Question 1
Answer A is incorrect. Lease contracts within the scope of HKFRS 16 are scoped out
of HKFRS 15.
Answer B is incorrect. Financial instruments within the scope of HKFRS 9 are scoped out
of HKFRS 15.
Answer C is correct. An entity’s contracts with its customers relating to outputs of the
entity’s ordinary activities are within the scope of HKFRS 15.
Answer D is incorrect. This transaction is a non-monetary exchange between entities in
the same line of business to facilitate sales to customers. Such exchanges are scoped out
of HKFRS 15.
Question 2
Answer A is correct. A contract to purchase a business is treated in accordance with HKFRS
3 Business Combinations and not HKFRS 15.
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Answer B is incorrect. HKAS 16 Property, Plant and Equipment directs entities to apply the
revenue recognition policies in HKFRS 15 to determine the gain or loss on sale of property,
plant and equipment.
Answer C is incorrect. Contracts to sell inventory to customers are within the scope of HKFRS 15.
Answer D is incorrect. An entity applies HKFRS 15 to those components of a contract with a
customer not addressed by another HKFRS.
Question 3
No is the correct answer. Though both parties may have signed an agreement, as of
15 January 20X0, each party has the unilateral enforceable right to cancel the wholly
unperformed contract without compensating the other party. The contract is wholly
unperformed because no goods have been provided to Beta Hardware (the customer) and
Hardware Distribution Plus (the supplier) is not yet entitled to receive any consideration.
Question 4
Answers A, B and D are incorrect. Such criteria are required for a contract to be accounted
for in accordance with HKFRS 15. It is also required that the payment terms are identifiable
and that the entity will probably collect the consideration to which it will be entitled in
exchange for the good or services to be transferred to the customer.
Answer C is correct. Goods or services do not have to be transferred for the contract
criteria to be met. For example, an entity would account for the incremental costs of
acquiring a contract (e.g. sales commissions) in accordance with HKFRS 15 prior to
transferring promised goods or services to the customer; this is discussed in Section 5.3.
Question 5
Answer A is incorrect. This treatment would be appropriate where the scope increases
due to the addition of distinct goods and services and the price increase do not reflect the
stand-alone selling price for the additional goods/services.
Answer B is correct. The contract modification results in (1) an increase in the scope of
the contract and (2) an increase in the amount of consideration that reflects the entity’s
stand-alone selling piece of the additional goods to be transferred. Such modifications are
accounted for as a separate contract.
Answer C is incorrect. This treatment would be appropriate where the remaining goods
and services to be transferred are not distinct.
Answer D is incorrect. This treatment would be appropriate where the remaining goods
and services to be transferred are a combination of goods that are (1) distinct from those
already transferred and (2) not distinct from those already transferred.
Question 6
There is one performance obligation in this contract, which is the promise to deliver a
shopping mall. Though the individual goods and services are capable of being distinct
because a customer could benefit from it separately or together with other readily available
resources, they are not distinct within the context of this contract. The goods are not distinct
within the context of the contract as each good or service is not separately identifiable from
other goods and services in the contract because the entity is providing a significant service
of integrating the goods and services (i.e. inputs) into the shopping mall (i.e. output).
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Question 7
Zoom is likely to recognise revenue from the sale of electricity to its customers over
time. Zoom’s promise to transfer electricity is satisfied over time as Zoom’s customers
simultaneously receive and consume the benefits of the electricity supplied as Zoom
performs under the contract.
Question 8
Answer A is incorrect. This method is most appropriate where the contract has a binary
outcome, for example, the customer is entitled or not entitled to a discount). In this case,
there are a range of possible discounts.
Answer B is correct. The entity is a large telecommunications company and, therefore,
contracts with many customers. As such, the entity would be able to probability-weight the
range of consideration amounts based on its significant historical experience.
Answer C is incorrect. The billed amount is not a method permitted by HKFRS 15 for
estimating variable consideration.
Answer D is incorrect. The average amount is not a method permitted by HKFRS 15 for
estimating variable consideration.
Question 9
Answers A and D are incorrect. HKFRS 15 requires consideration payable to a customer to
be included in the estimate of the transaction price.
Answer B is correct. The payment to the customer (retailer) is not in exchange for the
transfer of a distinct good or service to the manufacturer. Accordingly, the payment should
be accounted for as a reduction in the contract’s transaction price (i.e. [1,000 kettles * $50
per unit] less $2,500 consideration payable to the customer).
Answer C is incorrect. The manufacturer does not obtain control of the retailer’s shelving
and, therefore, it cannot be recognised as property, plant and equipment. Also, HKFRS
15 requires consideration payable to a customer to be included in the estimate of the
transaction price.
Question 10
The telecommunications company identifies three distinct performance obligations in the
contract: the handset, data allowance and tablet computer. Under HKFRS 15, the tablet
computer is not accounted for as a marketing expense because, like other goods and
services, it represents a performance obligation of the telecommunications company.
There is no indication the discount in the contract relates to some, but not all, the
performance obligations in the contract. Accordingly, the transaction price is allocated to each
of the three performance obligations on a relative stand-alone selling price basis as follows:
Transaction Performance Stand-alone Allocation of transaction price
price obligation selling price
24 * 480 = Handset HK$4,536 (HK$4,536 / HK$15,120) * HK$11,520 = HK$3,456
HK$11,520 Data allowance 24 * HK$315 = (HK$7,560 / HK$15,120) * HK$11,520 = HK$5,760
HK$7,560
Tablet computer HK$3,024 (HK$3,024 / HK$15,120) * HK$11,520 = HK$2,304
HK$15,120 HK$11,520
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Question 11
The telecommunications company will recognise revenue from the sale of the handset and
tablet computer at a point in time when control passes to the customer. Therefore, the
company will recognise HK$5,760 (HK$3,456 HK$2,304) on day one. The data allowance
represents a performance obligation satisfied over time. Using an output method, the
company will recognise 12 months of revenue from the provision of the data services,
amounting to HK2,880 (12/24 * HK$5,760). The total amount of revenue recognised
12 months through the contract is HK$8,640.
Question 12
Answers A and B are incorrect. HKFRS 15 requires the costs that meet the criteria for
recognition as an asset be capitalised; an entity does not have an accounting policy choice
in this regard.
Answer C is incorrect. Capitalised contract costs are recognised as an expense rather than
a reduction of the transaction price of the contract. However, they are amortised to profit
or loss on a systematic basis that is consistent with the transfer to the customer of the
goods or services to which the asset relates.
Answer D is correct. The costs of obtaining a contract or of fulfilling a contract must be
recoverable before the costs can qualify for recognition as an asset. Also, the asset must
be written down when the remaining amount of consideration that the entity expects to
receive exceeds the capitalised costs.
Question 13
Answers A and B are incorrect. HKFRS 15 requires capitalised costs be amortised on
a systematic basis that is consistent with the transfer to the customer of the goods or
services to which the asset relates. A amortises the costs on a straight-line basis over the
term of the contract rather than on a basis consistent with the transfer to the customer
of the goods or services to which the asset relates. B amortises the costs on a basis that
matches costs to revenue recognised. Armadale should recognise amortisation expenses
of HK$24,000 (40% HK$60,000).
Answer C is correct. In accordance with HKFRS 15, Armadale will need to write down the
remaining capitalised costs to nil because the costs are not recoverable.
Answer D is incorrect. Revenue recognised to date is not reversed in the event collectability
under the contract is in doubt; however, any capitalised contract costs, receivables and
contract assets should be tested for impairment.
Question 14
Answer A is incorrect. Measurement of the refund liability will reflect the entity’s
expectations of the amount of refunds it expects to make.
Answer B is incorrect. The entity will recognise revenue on transferring the good or service
to the customer, as the customer gains control of the asset.
Answer C is correct. Paragraph B25 of HKFRS 15 requires the asset representing an entity’s
right to recover products on settling a refund liability to be measured at the pre-sale carrying
amount of the good or service in the entity’s books, less any expected costs of recovery.
Answer D is incorrect. HKFRS 15 requires the assessment to be updated at the end of each
reporting period.
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Question 15
TravelCo recognises HK$600 as commission revenue. In this arrangement, TravelCo
concludes it is acting as an agent because it does not control the ticket conveying a right to
receive a flight before that ticket is transferred to Qin. In reaching this conclusion, TravelCo
observes that (1) the ticket is created only at the time it is transferred to Qin and, thus,
does not exist before the transfer, (2) the airline carrier is primarily responsible for fulfilling
the promise to provide Qin a flight to New York and (3) TravelCo is not exposed to any
inventory risk in relation to the flight ticket (as it is issuing the ticket on behalf of the airline
carrier). Consequently, TravelCo is merely conducting a service of arranging the flight and
recognises revenue only to the amount not remitted to the airline carrier.
Question 16
None of the statements is true.
Answer A is incorrect. A store warranty is a service-type warranty which is treated as a
separate performance obligation. Revenue is recognised as that performance obligation is
satisfied, which would normally be evenly over the warranty period. A separate provision
for the warranty claim is not recognised for store warranties.
Answer B is incorrect. Physical possession does not dictate the entity that controls
the product; however, it can be an indicator of control. For example, in a consignment
arrangement, the product is no longer in the physical possession of the seller; however,
other features of a consignment arrangement indicate that control of the product remains
with the seller. Another example is a bill-and-hold arrangement where the terms are such
that the customer now has the ability to direct the use of and obtain substantially all of
the remaining benefits from the product even though the product is still in the physical
possession of the seller.
Answer C is incorrect. Control of the product may be transferred where a customer does
not have a significant economic incentive to exercise its put option.
Answer D is incorrect. The likelihood of customers exercising their option to goods offered
under a customer loyalty programme is taken into account in estimating the stand-alone selling
price of the option, which impacts the allocation of the transaction price between the option
and other performance obligations in the contract. Breakage is also considered in an entity’s
determination of the extent to which the contract liability relating to the option is satisfied.
Question 17
Answer A is incorrect. The entity must first determine whether the licence is a performance
obligation. A licence that is not a distinct good is not separately recognised as a performance
obligation.
Answer B is incorrect. The entity must determine whether the licence gives the customer a
right to use the intellectual property (IP) under licence, or a right to access the IP under licence,
to determine whether the performance obligation is satisfied over time or at a point in time.
Answer C is correct. Where the promised consideration is in the form of a sales-based or
usage-based royalty, the general variable consideration constraint does not apply. Instead,
HKFRS 15 requires revenue to be recognised at the later of the time of sale and usage and
the time the related performance obligation is satisfied or partially satisfied.
Answer D is incorrect. This is only one of the conditions that must be met before the entity
can determine whether it has promised to provide a right to access IP.
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EXAM PRACTICE
QUESTION 1
On 20 December 20X0, Richmond Limited (Richmond) sells 100 crates of its latest beer
‘Dusty’ for HK$1,000 per crate to customers. Richmond’s website displays the satisfaction
guarantee ‘If you’re not 100% satisfied, you can return your order to us for a full refund
within 30 days, your choice’. Each crate costs Richmond HK$450 to produce.
Richmond expects of every 100 crates sold there is a:
• 70% probability that no beer will be returned
• 20% probability that five crates will be returned
• 10% probability that three crates will be returned
The following additional information is available:
• Richmond regularly sells Dusty at HK$1,000 per crate
• Richmond has been operating for 20 years, and its past experience across all its
beer products shows a consistent product return history
Richmond’s accounting policy is to recognise revenue when the sale transaction occurs at
the amount of the sale. Richmond recognises a decrease in revenue when a crate of beer
is returned.
Required:
Analyse Richmond’s revenue recognition accounting policy for compliance with HKFRS
15 and determine the amount of any over or understatement of revenue, if any, at the
time of sale.
QUESTION 2
On 15 November 20X1, Lexicon Limited (Lexicon) enters into a contract with customer
Verb Limited (Verb) to sell Verb a bundle of goods comprising pens, paper and a dictionary
for HK$500. Lexicon normally sells a bundle comprising the pens and paper together for
HK$450. Under the terms of the contract, Verb will pay for the goods upfront. The items
are on backorder, and Lexicon expects to deliver the goods within 180 business days rather
than the usual 10 days. Lexicon will ship each product as it becomes available. Lexicon’s
incremental borrowing rate is 6%.
The stand-alone selling prices of the products are:
Pens HK$150
Paper HK$360
Dictionary HK$90
Required:
Lexicon’s management is uncertain whether the backorder affects its accounting for the
contract and how to treat the discount in the contract and has asked for your input. Prepare
a file note addressing these two concerns and showing the allocation of the transaction price
across the identified performance obligations in the contract.
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FINANCIAL REPORTING
QUESTION 3
On 10 January 20X1, Sky High Limited (Sky High) enters into a non-cancellable contract to
construct a cinema multiplex on customer-owned land for consideration of HK$20 million.
Sky High will receive a performance bonus of HK$2 million if the building is completed within
26 months. At contract inception, Sky High:
• Expects the gross margin on the contract to be 35%;
• Considers it is not highly probable that a significant reversal in cumulative revenue
recognised will not occur when the uncertainty regarding its entitlement to the
performance bonus is resolved; and
• Determined that the performance obligation in the contract is satisfied over
time, and is appropriate to measure the contract on the basis of relative
costs incurred.
By the end of the financial year ended 31 December 20X1, Sky High has incurred
contract-related costs of HK$4.2 million. Sky High has not changed its evaluation whether
it will receive the performance bonus.
Required:
(a) Sky High’s auditors have queried Sky High’s determination that the performance
obligation is satisfied over time rather than at a point in time. Determine whether you
agree with Sky High or its auditors. Justify your response.
(b) Calculate the cumulative revenue recognised on the contract by the end of the financial
year ended 31 December 20X1.
(c) Sky High’s accounting team has prepared the following draft disclosure for inclusion in
the financial statements for the year ended 31 December 20X1.
‘X% of the transaction price is allocated to unsatisfied performance obligations as of
31 December 20X1. Sky High expects to recognise these amounts as revenue in the years
ended 31 December 20X2 and 20X3’.
Critique the disclosure and suggest improvements.
QUESTION 4
(This question is a continuation of Question 3)
On 22 February 20X2, Sky High and the customer agree to modify the design of the
multiplex in exchange for an increase of HK$3 million of consideration. Sky High expects
the total contract costs to increase by HK$1.2 million as a result of the modification.
Between 31 December 20X1 and 22 February 20X2, Sky High incurred a further HK$310,000
in contract costs. Sky High has not changed its evaluation whether it will receive the
performance bonus.
By the end of the financial year ended 31 December 20X2, Sky High has incurred cumulative
contract-related costs of HK$7.79 million. The company has invoiced the customer for 98%
of progress billings, with the balance payable on completion. Sky High now believes there is
a 95% likelihood that the cinema multiplex will be completed within 26 months.
Sky High completes the construction on 31 January 20X3. Total costs incurred on the project
were HK$8.5 million.
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R evenue
Required:
(a) Analyse the contract modification and explain its impact on the financial statements.
(b) Calculate the revenue Sky High recognises for the financial year ended 31
December 20X2.
QUESTION 5
Abel Co (Abel), an audit practice, recently won a tender to be the auditors of Trilling Limited
(Trilling) for the next three years. The overall contract is estimated to be worth about HK$50
million to Abel.
Abel incurred the following costs when bidding for the tender of Trilling:
• Costs of preparing the tender document.
• Salaries of staff seconded to the tender team.
• External coach hired to coach the tender team on the tender presentation.
Trilling is a broadcast television network. Trilling’s revenue-generating operations include
earning revenues from sales of DVD box sets of TV shows and from licences to other
networks to allow them to air Trilling-produced content:
DVD box sets
Trilling sells box sets of both Trilling-produced content and box sets of TV shows produced
by its sister company Hiccup Limited (Hiccup). There is no right of return for a refund
for change of mind, but if a box set is damaged, the customer is able to return it for
a replacement product. Trilling sometimes offers 20% off promotional discounts on
its box sets.
For every Hiccup box set sold, Trilling must remit to Hiccup a payment of HK$10. At the start
of each month, Trilling reviews its inventory and makes a non-refundable order to Hiccup.
Along with the order, Trilling receives a recommended retail price sheet from Hiccup. Trilling
does not need to follow the suggested pricing. In fact, in Trilling’s own retail price sheet, it
regularly sells Hiccup products for a price higher than the suggested price as it is the sole
distributor in its particular region.
Licences
Trilling sells licences to other networks, allowing them to air specified Trilling-produced
content in a particular geographical location. Trilling sells both licences over completed
seasons of TV shows and licences over current season 13-episode TV shows that are in
development. The other network is responsible for any marketing it wishes to do to promote
that it is airing the purchased TV show on its network, but the marketing must include that
the show is produced by Trilling. Trilling has no responsibility for advertising that a particular
TV show is also viewable on another network.
Trilling recognises revenue on the sale of a box set at the amount of the item on its price list
at the time of sale. Trilling recognises revenue on the sale of a Hiccup box set at the amount
of the item on its price list at the time of sale less the payment of HK$10 to be remitted to
Hiccup. Any discount on the sale is treated as a marketing expense. Revenue from licences is
recognised over the period of the licence, regardless of the form of consideration received.
In addition, Trilling recognises a provision for warranty claims.
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FINANCIAL REPORTING
Required:
(a) Assume you are the audit senior on the Trilling audit. Analyse its revenue recognition
policies for the box sets and licences for compliance with HKFRS 15. Prepare a file note
to document your analysis and conclusions.
(b) Abel’s finance team has tentatively decided Abel can recognise these costs as assets
and amortise the cost evenly over the three years of its contract with Trilling. As you sit
next to the finance team members, they have asked you to comment on the proposed
accounting. Determine whether the proposed accounting for the contract costs
incurred is appropriate.
ANSWERS TO EXAM PRACTICE
QUESTION 1
Richmond’s accounting policy is only partly in compliance with the requirements of HKFRS 15
because revenue should not be recognised at the time of sale for those crates of beer that
Richmond expects to be returned. HKFRS 15 requires:
• All performance obligations in the contract to be identified (Step 2) – Richmond
correctly identifies that its sole performance obligation in the contract is its promise
to transfer beer to the customer as the customer can benefit from each crate
of beer on its own and there are no other goods or services transferred in the
arrangement;
• The transaction price to be determined (Step 3) – Richmond has identified that its
transaction price for each crate is its sale price, being the regular stand-alone selling
price of the beer. However, as HKFRS 15 limits the amount of revenue that can be
recognised to the amount of consideration to which Richmond expects to be entitled,
Richmond should not recognise the refund transaction only when it occurs but reflect
it in its estimate of transaction price when the sale transactions are initially recognised.
In effect, Richmond’s accounting policy reflects accounting for each sale contract by
contract and assessing the transaction price, and likelihood of product return, on a
most likely outcome basis. However, as Richmond has a large number of contracts
with similar characteristics, Richmond should estimate the transaction price using the
expected value method, applying HKFRS 15 if it wishes to a portfolio of contracts. Using
the expected value method will result in an amount not immediately recognised as
revenue, reflecting that possible return of several crates of beer;
• The transaction price to be allocated to the performance obligations in the contract
(Step 4) – Richmond correctly allocates the transaction price solely to the crate
of beer; and
• Revenue to be recognised when (or as) each performance obligation is satisfied
(Step 5) – Richmond correctly recognises revenue at the time beer is transferred to the
customer, as at the point of sale the customer gains control of the beer.
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R evenue
In accordance with HKFRS 15, Richmond should not recognise revenue at the time of sale
for the products it expects to be returned but instead recognise a refund liability and an
asset (and corresponding adjustment to cost of sales) for its right to recover products from
customers on settling the refund liability. The effect of applying Richmond’s accounting
policy is an overstatement of revenue by HK$1,300 at the time of sale, calculated
as follows:
The estimate of transaction price using the expected value method is
100 HK$1,000 70% = HK$70,000
95 HK$1,000 20% = HK$19,000
97 HK$1,000 10% = HK$9,700
HK$98,700
Revenue recognised at the time of sale under Richmond’s accounting policy is HK$10,000.
Therefore, revenue is overstated by HK$1,300 (HK$10,000 − HK$98,700). This amount should
instead be recognised as a refund liability.
(Richmond uses the expected value method to estimate the variable consideration as there
is a large number of contracts with similar characteristics. Though product returns are out of
Richmond’s control, as Richmond’s long past experience across all its beer products shows a
consistent product return history and given the short [30-day] return period, Richmond may
conclude a significant reversal in the cumulative amount of revenue recognised will probably
not occur over the return period and, accordingly, the variable consideration included in its
estimate of transaction price is not constrained.)
QUESTION 2
File note: Effect of the backorder and discount on the accounting for the contract with Verb
Preparer: (name)
Date: Day/Month/Year
Backorder
Because the products are on backorder, there will be a delay between the time Lexicon
receives consideration and the time it transfers the products to Verb. Accordingly, Lexicon
needs to consider whether the contract includes a financing element that represents
interest revenue to Lexicon instead of revenue from the sale of the products. In
accordance with HKFRS 15, a significant financing element must be treated in accordance
with HKFRS 9 and does not form part of the revenue from the sale of the products.
Having regard to the facts and circumstances, the contract with Verb does not include a
significant financing element as the upfront amount is not made with the primary purpose
of obtaining financing from Verb but is part of the entity’s usual terms and conditions. The
items would, if not on backorder, have dispatched within a short time. Accordingly, that
the products are on backorder does not affect the amount recognisable as revenue from
the sale of the products. As Lexicon has received consideration but has not yet transferred
the products (i.e. satisfied its performance obligations under the contract), Lexicon
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FINANCIAL REPORTING
records the following journal at contract inception until such time as the products are
transferred to Verb:
Debit Credit
HK$ HK$
Cash 500
Contract liability 500
Discount
HKFRS 15 requires a discount to be allocated to the performance obligations in the contract
in proportion to their relative stand-alone selling prices except where the discount relates
only to specific performance obligations in the contract.
First, Lexicon must identify the performance obligations in the contract. In this contract,
Lexicon has three performance obligations: its promise to transfer pens, promise to transfer
paper and promise to transfer a dictionary. The three goods are distinct because:
• Verb can benefit from each of pens, paper and the dictionary on its own as each is
regularly sold separately; and
• Lexicon’s promise to transfer each item is separately identifiable from its other
promises in the contract as each item can be delivered at a separate time.
Next, Lexicon determines whether the discount should be allocated to all the performance
obligations or only some of the performance obligations in the contract. A review of the
relevant facts and circumstances show that though Lexicon, on a stand-alone basis, sells
a bundle of pens and paper at a discount to its stand-alone selling prices, that discount
(HK$60) is not substantially the same as the discount in the contract (HK$100). Accordingly,
in accordance with HKFRS 15, the discount in the contract must be allocated proportionately
across the pens, paper and dictionary as no observable evidence shows that the discount
can be attributed to only some of the performance obligations in the contract.
Allocation of transaction price
Hence, the transaction price is allocated to the performance obligations in the contract
as follows:
Promised good Allocation of transaction price
Pens HK$125 (calculated as HK$150/(HK$150 HK$360 HK$90) * 500)
Paper HK$300 (calculated as HK$360/(HK$150 HK$360 HK$90) * 500)
Dictionary HK$75 (calculated as HK$90/(HK$150 HK$360 HK$90) * 500)
HK$500
QUESTION 3
(a) In accordance with HKFRS 15, a performance obligation is satisfied over time where the
entity’s performance creates or enhances an asset that the customer controls as the
asset is created or enhanced. In this contract, the customer controls the building work
in progress asset as the cinema multiplex is being constructed on customer-owned land
(accordingly, the customer can deny Sky High access to the site). Accordingly, agree with
Sky High’s determination that the performance obligation in the contract is satisfied
over time rather than at a point in time.
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R evenue
(b) The expected contract costs are HK$7 million (65% HK$20 million); that is, Sky
High has satisfied 60% of its performance obligation (HK$4.2 million/HK$7 million
= 0.6). Accordingly, by the end of the reporting period Sky High will have recognised
cumulative revenues of HK$12 million relating to the contract (0.6 * HK$20 million).
(c) The draft disclosure discloses the percentage incomplete on the contract rather than
the aggregate amount of the transaction price allocated to unsatisfied performance
obligations, which is required by HKFRS 15. As the percentage of completion varies
with the relative costs incurred, this provides the user with less useful information than
disclosure of the aggregate amount. Sky High should disclose the aggregate amount of
the transaction price allocated to unsatisfied performance obligations (HK$8 million).
The draft disclosure inadequately explains when Sky High expects to recognise as
revenue the outstanding consideration it expects to be entitled to because it is unclear
to what extent the revenue will be recognised in 20X2 or 20X3. Sky High should disclose
to what extent it expects revenue on the contract to be recognised in 20X2 and 20X3
either qualitatively or using an annual time band.
In addition, Sky High should disclose that the HK$2 million performance bonus has
been excluded from its present estimate of the contract’s transaction price.
QUESTION 4
(a) Sky High should treat the contract modification as an adjustment to the existing
contract because the nature of Sky High’s promise to the customer is to transfer
a cinema multiplex. Accordingly, the remaining goods and services to be provided
under the modified contract are not distinct from the goods and services transferred
before the modification; instead, they are all inputs into the combined output: the
multiplex.
Accordingly, on the date of modification, Sky High adjusts its accounting for the
contract as though the modification had always existed. Sky High makes a cumulative
catch-up adjustment on 22 February 20X2 to recognise additional revenue of
HK$650,000, determined as follows:
• Revised total contract costs – HK$8.2 million (HK$7 million HK$1.2 million)
• Contract costs incurred to date – HK$4.51 million (HK$4.2 million HK$310,000)
• Progress of satisfaction of the performance obligation – 55% (4.51/8.2)
• Revised estimate of transaction price – HK$23 million (HK$20 million HK$3 million)
• Cumulative revenue under the relative costs incurred method – HK$12.65 million
(HK$23 million 55%)
• Cumulative revenue recognised to date (original contract) – HK$12 million
• Cumulative catch-up adjustment required – HK$650,000 (HK$12.65 million −
HK$12 million)
(b) Sky High recognises revenue of HK$11.1 million for the financial year ended
31 December 20X2, determined as follows:
• Percentage completed to date = 95% (HK$7.79 million/HK$8.2 million)
• Revised estimate of transaction price = HK$25 million (HK$23 million HK$2 million)
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FINANCIAL REPORTING
• Cumulative revenue to recognise = HK$23.75 million (95% HK$25 million)
• Revenue to recognise in 20X2 = HK$11.1 million (HK$23.75 million − HK$12.65 million)
QUESTION 5
(a) File note: Revenue recognition accounting policies – Trilling
Prepared by: (name)
Dated: DD/MM/YYYY
Trilling generates revenue from sales of Trilling-produced box sets, Hiccup-produced
box sets and from sales of licences over Trilling-produce TV shows.
Trilling-produced box sets
Trilling’s accounting policy is to recognise revenue on the sale of a Trilling-produced box
set at the amount of the item on its price list at the time of sale. Any discount on the
sale is treated as a marketing expense.
• Performance obligations correctly identified – Yes. Each promise to transfer a box set
to the customer is a separate performance obligation in the contract with a customer.
No other promised goods or services are transferred in the contract because the
warranty is not a distinct service transferred. The warranty is not distinct because
the customer does not have the option to buy it separately and no reasons exist to
believe the warranty offers the customer any services in addition to the assurance the
box set complies with agreed-upon specifications (i.e. that it can be played).
• Transaction price correctly identified – No. Trilling does not treat discounts as a
reduction of its transaction price but as a marketing expense. In accordance with
HKFRS 15, the discount must be considered as part of estimating the transaction
price and, hence, revenue of the contract. Accordingly, total revenues and total
expenses will be overstated.
• Transaction price appropriately allocated to performance obligations – Yes, with the
qualification that the transaction price is overstated by the amount of any discount.
This is observable from Trilling’s accounting policy, which indicates that revenue is
recognised ‘at the amount of the item on its price list’.
• Timing of revenue recognition is appropriate (timing of satisfaction of the
performance obligations) – Yes. Because the box set is transferred to the customer
at the point of sale, the customer is able to direct the use and obtain substantially
all the benefits from the box set (i.e. play it) from this time. Further, the customer
has no right to return the product for a refund. Accordingly, at the point of sale,
Trilling has satisfied all its performance obligations in the contract.
Conclusion: Trilling’s revenue recognition accounting policy for Trilling-produced box sets is
not in accordance with HKFRS 15 as it fails to recognise discounts as a reduction of revenue.
Hiccup-produced box sets
Trilling’s accounting policy is to recognise revenue on the sale of a Hiccup box set at the
amount of the item on its price list at the time of sale less the payment of HK$10 to be
remitted to Hiccup. Any discount on the sale is treated as a marketing expense.
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R evenue
• Performance obligations correctly identified – Yes. Because Trilling is on-selling
Hiccup products whether Trilling is acting as a principal or agent in the transaction
must be considered. A review of the accounting policy suggests that Trilling
considers it is acting as a principal because it recognises revenue at the amount per
its price list. Concur that Trilling is acting as a principal because Trilling controls the
products after it acquires them from Hiccup as Trilling carries the inventory risk of
the Hiccup box sets (the items are non-refundable) and can set the sale price of the
Hiccup box sets. Accordingly, the nature of Trilling’s promise is correctly identified
as a performance obligation to transfer the Hiccup box set. Per the Trilling box
sets, each promise to transfer a box set to the customer is a separate performance
obligation in the contract with a customer and no other promised goods or services
are transferred in the contract because the warranty is not a distinct service
transferred.
• Transaction price correctly identified – No, see analysis in Trilling box sets. In
addition, the transaction price should not be reduced by the amount remittable
to Hiccup. As Trilling controls the items before the sale, this amount is a
cost of sale (e.g. affects the cost of inventory) rather than a reduction of the
transaction price.
• Transaction price appropriately allocated to performance obligations – Yes, with
the qualification that the transaction price is overstated by the amount of any
discount and understated by the amounts remitted to Hiccup. This is observable
from Trilling’s accounting policy, which indicates that revenue is recognised ‘at the
amount of the item on its price list’.
• Timing of revenue recognition is appropriate (timing of satisfaction of the
performance obligations) – Yes. Because the box set is transferred to customer at
the point of sale, the customer can direct the use and obtain substantially all the
benefits from the box set (i.e. play it) from this time. Further, the customer has no
right to return the product for a refund. Accordingly, at the point of sale, Trilling has
satisfied all its performance obligations in the contract.
Conclusion: Trilling’s revenue recognition accounting policy for Hiccup-produced box sets
is not in accordance with HKFRS 15 because it fails to recognise discounts as a reduction
of revenue and treats the amounts remitted to Hiccup as a reduction of revenue.
Licences
Trilling’s accounting policy is to recognise revenue from licences is recognised over the
period of the licence, regardless of the form of consideration received.
• Performance obligations correctly identified – Yes. Each licence is a distinct good
and a performance obligation in the contract. No other promised goods or services
are transferred in the contract.
• Transaction price correctly identified – Unknown. Further information is required
about the form of the consideration to determine whether the total amount of
revenue recognisable is appropriately determined.
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• Transaction price appropriately allocated to performance obligations – Probably,
because there is a single performance obligation in the contract.
• Timing of revenue recognition is appropriate (timing of satisfaction of the
performance obligations) – No.
Licences over current season 13-episode TV shows:
For a licence over a current season TV show in development:
°° Trilling has a contractual or implied obligations to change the existing
intellectual property (IP) by developing new episodes in the season to a
total of 13 episodes. Because the season is currently in development, the
ability of the customer to obtain the benefits of the licence is substantially
derived from, or dependent on, Trilling’s ongoing activity to produce the
new episodes. Accordingly, the customer reasonably expects (arising from
Trilling’s customary business practices) Trilling to undertake activities that
significantly affect the IP that is the subject of the licence.
°° The rights granted by the licence directly expose the customer to both positive
and negative effects of the entity’s activities because the customer has no
control over the content or production of the episodes.
°° Even though the customer may benefit from those activities (new episodes)
through the rights granted by the licence, they do not transfer a further good or
service to the customer as those activities occur.
Consequently, the nature of Trilling’s promise in transferring the licence over
the in-development 13-episode season is to provide the customer with a right to
access the entity’s IP, i.e. the performance obligation is satisfied over time. Hence,
recognition of the revenue over the period of the licence is appropriate; however,
the form of the consideration (e.g. a sales based royalty) could affect the timing of
the recognition of revenue during the period of the licence.
Licences over a completed season of a TV show:
Because Trilling is providing access to completed seasons of the TV series, Trilling
assesses that it does not have any contractual or implied obligations to change
the licenced television series. Further, as the licenced series has significant stand-
alone functionality (i.e. the ability to be aired in its current condition), the ability of
the customer to obtain the benefits of the licence is not substantially derived from
Trilling’s ongoing activities. Accordingly, Trilling concludes that the contract does
not require, nor does the customer reasonably expect, it to undertake activities that
significantly affect the IP that is the subject of the licence.
Consequently, the nature of Trilling’s promise in transferring the licence is to
provide the customer with a right to use the entity’s IP as it exists at the point in
time that it is granted; i.e. the performance obligation is satisfied at a point in time.
Hence, recognition of the revenue over the period of the licence is not appropriate.
Further, the form of the consideration (e.g. a sales-based royalty) could affect the
timing of the recognition of revenue.
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R evenue
Conclusion: More work is required to determine the extent to which Trilling’s revenue
recognition accounting policy for licences is not in accordance with HKFRS 15.
(b) The costs of preparing the tender document and the cost of the external coach can be
recognised as assets in accordance with HKFRS 15 because the costs are incremental
costs of obtaining a contract which Abel expects to recover through its margin on the
contract. The salaries of staff seconded to the tender team cannot be recognised as
an asset in accordance with HKFRS 15 because the cost would have been incurred
regardless of whether the tender was won and is not explicitly on-chargeable to Trilling.
The proposal to amortise the capitalised costs evenly over the three-year contract
is inconsistent with HKFRS 15 because HKFRS 15 requires capitalised costs to be
amortised on a systematic basis consistent with the transfer to the customer of the
goods or services to which the asset relates: The transfer of audit services occurs
unevenly over a calendar year.
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6
Inventories
CHAPTER TOPIC LIST
6.1 Overview 6.3 Recognition as an Expense
6.1.1 Scope 6.4 Disclosure
6.1.2 Terminology
6.2 Measurement of Inventories
6.2.1 Cost of Inventories
6.2.2 Cost Formulas
6.2.3 Net Realisable Value
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FINANCIAL REPORTING
LEARNING OUTCOMES
PRINCIPAL LO3: EVALUATE AND ADVISE ON APPROPRIATE ACCOUNTING PRINCIPLES TO
ACCOUNT FOR COMPLEX BUSINESS TRANSACTIONS
LO3.03: A
ccount for, evaluate and advise on business transactions in accordance with Hong Kong
Financial Reporting Standards as they relate to: Inventories
3.03.01 Describe the scope and definition of inventories
3.03.02 Use acceptable methods of assigning costs including the allocation of overheads to
inventories
3.03.03 Calculate the cost of inventories
3.03.04 Evaluate the potential impact of net realisable value falling below cost and make the
required adjustments
3.03.05 Advise on the appropriate accounting treatment to be adopted in respect of inventories
3.03.06 Analyse variances in a standard costing system
3.03.07 Prepare and appraise disclosure in respect of inventories
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Inventories
OPENING CASE
VISIONCO TVs
V isionCo TVs Limited (VisionCo) is a television manufacturer operating in Hong Kong.
VisionCo manufactures a range of televisions, including LCDs, LEDs and OLEDs.
VisionCo sources parts from suppliers throughout Asia. Other than the cost of parts, it pays
transport fees to procure the materials and a range of import duties, depending on the location
of the supplier. VisionCo’s suppliers offer trade discounts when the company purchases above
a specified amount of materials.
The company primarily manufactures the televisions in three large factories using a
manufacturing process that is mostly automated. Other than the price of procuring materials,
VisionCo’s costs include supervisor staff salaries, rent, administration, depreciation of
machinery, maintenance, electricity, oil and lubricants, storage and selling costs. All televisions
are manufactured using a similar process and are allocated an equal share of indirect costs.
During the year 20X1, VisionCo began manufacturing a new type of television, COLED,
which was based on new technology. Unlike the other types of televisions, the manufacturing
process was more complex, requiring additional manual intervention during and in between
batch runs. Due to an electrical fault, the first batch of 500 COLED televisions was damaged
beyond repair. The cost of the wasted materials was significant to VisionCo.
VisionCo was not the only manufacturer producing COLED televisions. Its largest
competitor, Optical TVs Limited, had just begun stocking retailers’ shelves with COLED
televisions. With COLED televisions now on the market, the demand for other televisions
dropped sharply. VisionCo took a loss on the last batch of LCDs sold to a local retailer.
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FINANCIAL REPORTING
OVERVIEW
As is the case for VisionCo, inventories are a material asset for many entities, and the way in
which they are measured can have a significant impact on an entity’s gross profit. VisionCo is
a manufacturer of different types of televisions, where each line of television is equipped with
different technologies. The cost of each television line will vary and, importantly, VisionCo must
employ suitable methods for measuring and allocating costs to its television inventories.
Different methods exist for measuring the cost of inventories, and depending on the
circumstances, inventories may be expensed in the statement of profit or loss and other
comprehensive income prior to or when revenue from the sale of such inventories is recognised.
This chapter considers the measurement of the cost of inventories, when inventories
are required to be written down to their net realisable value, and the required disclosures
to help users of financial statements understand how and when inventories are
recognised in the statement of financial position and statement of profit or loss and other
comprehensive income.
6 . 1 OVERVIEW
The accounting for inventories is set out in HKAS 2 Inventories. The primary issue dealt with in
HKAS 2 is establishing the amount recognised as an asset in the statement of financial position.
In this section, you will develop an understanding of the types of inventories to which
HKAS 2 applies and the terminology relevant to applying the HKAS.
6.1.1 Scope
HKAS 2 applies to all inventories, except:
• Financial instruments (see HKFRS 9 Financial Instruments) (see Chapter 12); and
HKAS • Biological assets related to agricultural activity and agricultural produce at the point of
2.2 harvest (see HKAS 41 Agriculture) (see Chapter 26).
In addition, HKAS 2 does not apply to the measurement of inventories held by:
• Producers of agricultural and forest products, agricultural produce after harvest, and
minerals and mineral products to the extent that they are measured at net realisable
value in accordance with well-established practices in those industries; and
HKAS
2.3 • Commodity broker-traders who measure their inventories at fair value less cost to sell.
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HKAS 2 requires changes in those current values to be recognised immediately in profit
or loss for the exclusion from the measurement requirements of the Standard to apply. The
remainder of the requirements of HKAS 2 apply to these inventories.
6.1.2 Terminology
Inventories are assets:
• Held for sale in the ordinary course of business;
• In the process of production for such sale; or
HKAS • In the form of materials or supplies to be consumed in the production process or in the
2.6 rendering of services.
Put another way, inventories can be categorised into three separate degrees of
completeness: inventories ready for sale (commonly known as finished goods), inventories being
converted into finished goods (commonly known as work in progress) and inventories that are
yet to begin being converted into finished goods (commonly known as raw materials).
HKAS Net realisable value (NRV) is the estimated selling price in the ordinary course of business
2.6 less the estimated costs of completion and the estimated costs necessary to make the sale.
Other than the terms noted above, HKAS 2 employs several terms commonly used in
managerial cost accounting. Such terminology is used when setting out the measurement of
cost (for example, direct costs, indirect costs, costs of conversion and standard costing) and cost
formulas (for example, first-in, first-out [FIFO] and weighted average cost). Accordingly, those with
knowledge of managerial cost accounting will be familiar with various terms used in this chapter.
6 . 2 MEASUREMENT OF INVENTORIES
HKAS
2.9 Inventories are measured at the lower of cost and net realisable value. Cost and net realisable
value are terms that are considered further in this section.
6.2.1 Cost of Inventories
As depicted in Exhibit 6.1, the cost of inventories comprises all costs of purchase, costs of
conversion and other costs incurred in bringing the inventories to their present location and
condition. For VisionCo, costs of purchase would include the acquisition of electronic parts,
and costs of conversion would include items, such as labour, depreciation of manufacturing
equipment and a share of overheads. Other costs may include the cost of designing new models,
such as the COLED television. The three types of costs are considered in more detail in the
following text.
Cost = Purchase price + Conversion + Other costs
EXHIBIT 6.1 Cost of inventories
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6.2.1.1 Costs of Purchase, Conversion and Other Costs
Costs of Purchase
The costs of purchase of inventories include the purchase price, import duties and other taxes,
transport, handling and other costs directly attributable to the acquisition of finished goods,
materials and services.
HKAS To the extent that an entity receives a trade discount, rebate or other similar item, the
2.11 entity must deduct that item when determining the cost of the purchase.
Costs of Conversion
Costs of conversion of inventories include costs:
• Directly related to the units of production, for example, direct materials and direct
labour; and
• Indirectly related and systematically allocated to the units of production, i.e. production
overheads.
Production overheads may be either fixed production overheads or variable production overheads.
Fixed production overheads are those indirect costs that remain relatively stable regardless of
the level of production activity, for example, costs of managing a factory and administrative
HKAS activities. Variable production overheads are those indirect costs that vary directly, or close to
2.12 directly, with the volume of production activity, for example, indirect materials and indirect labour.
The allocation of fixed production overheads to inventories is based on the normal capacity
of an entity’s production facilities. Normal capacity is the expected production on average over
several periods under normal operating conditions, taking into account routine maintenance.
To the extent that a plant is idle or experiences low production, the amount of fixed
production overheads allocated to each unit of production is not increased. Rather, unallocated
overheads (or unused capacity) is recognised as an expense in the period it is incurred. When
an entity experiences abnormally high production, the amount of fixed production overheads
HKAS allocated to each unit of production is decreased such that inventories are not measured
2.13 above cost.
HKAS Variable production overheads are allocated to each unit of production on the basis of
2.13 actual use.
Where a production process results in more than one type of product being produced
HKAS simultaneously and the costs of conversion are not separately identifiable, such costs are allocated
2.14 to each product on a rational and consistent basis, for example, relative sales value of each product.
Apply and Analyse 1
SteelProd Limited (SteelProd) produces steel for industrial use in mainland China. The steel
is produced in one manufacturing facility. The production process results in the output of
steel and blast furnace slag (a by-product). Steel is currently sold at HK$17,000 per tonne
and blast furnace slag is sold at HK$3,000 per tonne.
Under normal operating conditions, SteelProd produces 10 tonnes of steel per month
and two tonnes of blast furnace slag (BFS). Monthly fixed production overheads amount to
HK$40,000.
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Apply and Analyse 1 (continued)
For the month of October 20X2, 8 tonnes of steel and 1.6 tonnes of blast furnace slag
were produced.
Calculate the amount of fixed production overhead to be allocated to steel and blast
furnace slag for the month.
Analysis
SteelProd first determines an appropriate method of allocating the fixed production
overheads to each product. SteelProd determines it is appropriate to make the allocation
of the amount of fixed overheads to steel and BFS based on the relative sales price of each
product. This allocation basis is used because the products are produced simultaneously
and the costs of conversion are not separately identifiable.
Next, based on this allocation method, SteelProd determines the amount of fixed
production overheads allocated per tonne of each product by reference to production
under normal operation conditions:
Product Tonnes Sales price Total sales Fixed overhead Overhead
produced allocated per tonne
HK$ HK$ HK$ HK$
Steel 10 17,000 170,000 38,636 3,864
BFS 2 3,000 6,000 1,364 682
Total 176,000 40,000
The fixed production overheads included as part of the cost of the steel and BFS
inventory produced in October is calculated as:
HK$32,000 (8 tonnes of steel HK$3,864 1.6 tonnes of BFS HK$682). The excess of
HK$8,000 is immediately recognised as an expense.
Other Costs
Other costs are included in the costs of inventories to the extent that they are incurred in
HKAS bringing the inventories to their present location and condition (e.g. certain non-production
2.15 overheads or costs of designing products for specific customers).
The following are examples of costs that are not included in the cost of inventories but
would be recognised as an expense in the period in which they are incurred:
• Abnormal amounts of wasted materials, labour or other production costs.
• Storage costs, unless those costs are necessary in the production process before a
further production stage.
• Administrative overheads that do not contribute to bringing inventories to their present
location and condition.
HKAS • Selling costs, such as marketing costs, costs of sales staff or distribution costs (freight
2.16 outwards).
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For VisionCo, examples of costs that would not be included in the cost of inventories are:
Costs expensed in the period incurred Examples
Abnormal costs Wasted screens, housing units and electronics in the
production of newly developed televisions
Storage costs Depreciation of right-of-use asset for warehouse to
store the finished screens
Administrative overheads Depreciation of right-of-use asset for office space
dedicated to supporting administrative teams (human
resources, finance)
Selling costs Bonuses and commissions paid to sales teams
based on contracts signed with retailers and costs
of maintaining vehicles used to deliver televisions to
retail stores
Apply and Analyse 2
VisionCo produces a range of televisions, including LED units. VisionCo incurs several
costs in the procurement of parts, manufacture of finished goods and distribution of LED
units. During the month of September 20X1, VisionCo’s costs of manufacturing 5,000 LED
units were:
Item Cost
HK$
Purchase price of parts 900 per unit
Total trade discount received 150,000
Freight inwards 10 per unit
Import duties 50 per unit
Direct labour 100 per unit
Variable production overheads 150 per unit
Total fixed production overheads 1,000,000
Storage of finished goods 50,000
Freight outwards 15 per unit
Sales commissions 25 per unit
The fixed production overheads were budgeted to total HK$1 million and the normal
capacity for the production facility is output of 4,000 LED units per month.
Determine the cost per LED unit for the month of September 20X1 in accordance
with HKAS 2.
Analysis
VisionCo must include in the cost of its LED units the cost of purchases, costs of conversion
and other costs incurred in bringing the units to their present location and condition.
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Apply and Analyse 2 (continued)
The following costs will be included in the cost of each LED unit:
Costs Amount
per unit
HK$
Purchase costs
Purchase price of parts 900
Trade discount (30) [HK$150,000/5,000 units]
Freight inwards 10
Import duties 50
Costs of conversion
Direct labour 100
Variable production overheads 150
Fixed production overheads 200 [HK$1,000,000/5,000 units]
Total cost per unit 1,380
Purchase price of parts, trade freight inwards and import duties are included in the
cost of LED units as they are costs directly attributable to the acquisition of the parts. In
accordance with HKAS 2, the trade discount must be deducted from the purchase costs.
Direct labour, variable production overheads and fixed production overheads are
added to the cost of LED units as they are necessarily incurred to convert the parts into
finished goods.
Fixed production overheads are allocated based on the normal capacity of the
production facility. In VisionCo’s case, normal capacity is 4,000 LED units per month.
Therefore, the allocation of fixed overhead based on normal capacity would be equal to
HK$250 per unit (HK$1,000,000/4,000 units). However, when the level of production is
abnormally high, HKAS 2 requires that the amount of fixed overheads allocated to each
unit is reduced so that inventories are not measured above cost. Because the normal
capacity on which fixed overheads per unit is based is 80% of the actual production for
September 20X1 (i.e. 4,000 ÷ 5,000 units), the fixed overheads to be allocated per unit of
production in September 20X1 are 80% of the normal amount, i.e. HK$200 (calculated as
0.8 HK$250).
The costs to store finished goods is not allocated to the LED units because finished
goods storage is not required prior to production. The freight outwards and sales
commissions are not included in the cost of LED units because these are sales costs and
are not required to bring the units to their present location and condition.
6.2.1.2 Standard Cost Method
The goal when measuring the cost of inventories is to show the actual costs incurred
by the entity. Nevertheless, when measuring the cost of inventories, HKAS 2 permits
using measurement techniques, such as the standard cost method or the retail method,
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for convenience if the results approximate cost. Their use is often for reasons of simplicity and
reducing bookkeeping for individual inventory items. In addition, the standard cost method
may be used to integrate with the entity’s management accounting and cost control systems.
These methods are discussed below and in Section 6.2.1.3.
The standard cost method substitutes expected (standardised) costs for actual costs to
measure inventories as a simplified method of accounting for inventories. It is based on
observed costs under normal conditions and, thus, takes into account normal levels of
HKAS materials and supplies, labour, efficiency and capacity utilisation, which are reviewed regularly
2.21 and, where appropriate, changed to reflect new conditions. The approximation of the cost of
inventories using standard costs is suited to entities with sufficient historical data on inventory
costs (in particular, data on how costs behave over a range of outputs) and with inventory costs
that do not change rapidly.
Illustrative Example 1
VisionCo manufactures logic boards (which house transformers, capacitors and wiring
for each television) on premises. Although the components within each logic board may
differ, the housing unit is the same for all types of televisions sold by VisionCo.
VisionCo uses standard costing to measure the cost of logic boards. It calculates the
normal level of materials, labour, variable production overheads and fixed production
overheads per logic board as follows:
HK$
Materials 35
Labour 18
Variable production overheads 10
Fixed production overheads 50
Total cost per unit 113
As of 1 March 202X, VisionCo had no logic boards on hand. During the month of March
202X, VisionCo manufactured 3,000 units and used 2,000 units in televisions (finished
goods) that were sold during the month.
Management reported an unfavourable inventory cost variance of HK$9,000. On
further investigation, the cost variance consisted of an unfavourable materials price
variance of HK$15,000 and a favourable labour spending variance of HK$6,000.
The materials price variance had arisen due to higher than budgeted import duties that
could have been avoided had the company better understood the import duty rules. The
materials price variance was not considered to arise under normal operating conditions.
The abnormal purchase cost of HK$15,000 was recognised as an expense in full for the
month of March 202X because it did not reflect a change in supportable standard costs.
The labour spending variance had arisen due to improved labour efficiency, reducing
the amount of staff overtime. The variance was assessed as resulting from normal
operating conditions: therefore, in accordance with HKAS 2 para. 21, VisionCo reduced the
standard cost for labour from HK$18 per logic board to HK$16 (i.e. a reduction of HK$6,000
÷ 3,000 logic boards). Therefore, VisionCo reduced the cost of goods sold and ending
inventories by HK$4,000 (2,000 * HK$2) and HK$2,000 (1,000 * HK$2), respectively.
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6.2.1.3 Retail Method
Retail companies often use the retail method when measuring inventories of large numbers of
rapidly changing items with similar margins. In the retail industry, using other costing methods
can be impracticable because of the large number of rapidly changing items. When determining
the cost of inventories, the retail method begins with the total selling price of the item and
deducts a gross margin. For this reason, using the retail method is less appropriate for entities
with gross margins that fluctuate considerably.
Retail variety stores often perform a cost and sell exercise on a sample of goods to
establish the margin, whereby for a closed period of time an entity conducts a stocktake of a
sample of goods held and the price and cost of the goods selected are determined.
The percentage used takes into consideration inventories discounted to an amount less
HKAS than their original sales price. A retailer may apply different gross margin percentages to
2.22 different retail departments. For example, a fashion designer may realise a higher gross margin
in an inner-city location, when compared with a factory outlet.
Illustrative Example 2
YourFashionHQ Limited (YourFashionHQ) is a retailer of business and formal apparel.
YourFashionHQ purchases apparel from various manufacturers throughout Asia and
sells via retail outlets at an average gross margin of 20%.
Due to the broad range of apparel sold by YourFashionHQ, the company uses the
retail method to estimate the cost of sales and the costs of inventory on hand at the end of
each period.
During the March 20X8, the entity had total sales of HK$200,000. To determine the cost
of goods sold and the cost of ending inventory, YourFashionHQ subtracts the gross margin
from the sales value as follows:
HK$
Beginning inventory 130,000
Purchases 250,000
Less cost of goods sold (160,000)a
Ending inventory 220,000
a
cost of goods sold = Sales − (Sales * gross margin)
160,000 = 200,000 − (200,000 * 20%)
6.2.2 Cost Formulas
Section 6.2.1 explains what is included in the measurement of costs of inventories. In this
section, you will learn how to assign the costs of inventories to the inventories manufactured
during a period, sold during the period and on hand at the end of the period.
As illustrated in Exhibit 6.2, there are different possible cost formulas. The cost formula
used is dependent on the nature of the inventories. Where inventories are not ordinarily
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HKAS interchangeable or goods or services are produced and segregated for specific projects, the
2.23 cost of inventories should be specifically identified. Where inventory items are interchangeable,
IAS
2.BC 9
the costs are assigned to inventories using the first in, first out (FIFO) formula or the weighted
HKAS average cost formula. The last-in, first-out (LIFO) formula is not permitted. The same cost
2.25 formula is applied to all inventories of a similar nature and use to the entity.
Specific Weighted
FIFO identification average
EXHIBIT 6.2 Cost formulas
6.2.2.1 Specific Identification
Specific identification of cost results in specific costs being attributed to identified items of
inventory. This treatment of costs is appropriate for items that are segregated for a specific
project, irrespective of whether the items have been bought or produced. Similarly, where
inventory items have different features and, therefore, are not ordinarily interchangeable,
HKAS specific identification is necessary to faithfully represent the cost of inventory at the beginning
2.24 and end of the period and the cost of inventory sold during the period.
6.2.2.2 FIFO
The FIFO formula for costing inventories assumes that inventories purchased or produced first
HKAS are sold first. Accordingly, inventories on hand at the end of the period consist of items most
2.27 recently purchased or produced. The FIFO formula may be appropriate for fast moving or
perishable inventories. For example, the FIFO formula may be suitable for a company selling
seasonal plants where the cost of plants varies significantly depending on the time of year and
the availability of the plants.
6.2.2.3 Weighted Average Cost
Unlike the FIFO formula, the weighted average cost formula does not consider when
inventories were purchased or produced. Under the weighted average cost formula, the cost of
inventories is determined from the weighted average cost of similar items on hand at the
beginning of the period and the cost of similar items purchased on produced during the period.
HKAS Depending upon the circumstances of the entity, the weighted average cost may be calculated
2.27 periodically or as each purchase is made. The weighted average cost formula is suited to
inventories with stable input costs and that are not perishable.
For example, a retailer of bathroom tiles with a long-term fixed price supply contract may
use the weighted average cost formula.
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6.2.3 Net Realisable Value
As noted in Section 6.2, inventories are required to be carried at the lower of cost and net
realisable value. Net realisable value (NRV) is the estimated selling price in the ordinary course
of business less the estimated costs of completion (for example, conversion costs such as direct
HKAS labour) and the estimated costs necessary to make the sale (for example, marketing and
2.6 distribution costs).
A common misconception is that NRV is equal to fair value less costs to sell. Though the two
values may often be similar, they are not the same (Exhibit 6.3).
Net realisable value Fair value less costs to sell
Entity-specific measure Based on the price to be received in the principal
or most advantageous market
Based on the purpose for which the Based on general selling price in the
inventory is held relevant market
For partly completed inventories, NRV deducts Deducts the estimated costs of completion and a
the estimated costs of completion market-based profit margin
Takes into account whether a change in the Based on the market price at measurement date
selling price is temporary
EXHIBIT 6.3 Comparison of net realisable value and fair value less costs to sell
Assets are required not to be overstated; in the case of inventories, this means they should
not be measured at an amount exceeding the price expected to be realised from their sale.
The cost of inventories may not be fully recoverable when, for example:
• The inventories are damaged or obsolete;
• There has been a decline in the sales price; and
HKAS
2.28 • The estimated costs of completion or costs to make a sale have increased.
Where the estimated sales price is less than the cost of inventories, the inventories are
carried at NRV. An entity records a write-down of inventory as follows:
Debit Credit
HK$ HK$
Loss on write-down of inventories x,xxx
Inventories x,xxx
In most cases, inventories are written down to NRV on an item-by-item basis. However,
in some circumstances, grouping similar or related items is appropriate. The grouping of
inventories is acceptable where the inventories:
• Are of the same product line and have similar purposes or end uses;
• Are produced and marketed in the same geographical area; and
• Cannot be practically evaluated separately from other items in that product line.
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HKAS However, grouping is unacceptable when it is based on an entire classification, for example
2.29 work in progress, finished goods.
An entity estimates the NRV based on the most reliable evidence available at the time of the
assessment. The estimates take into account the fluctuations in sales price or cost that directly
HKAS relate to events occurring after the end of the reporting period to the extent that they confirm
2.30 conditions existing at the end of the reporting period.
When determining the NRV, an entity considers the purpose of the inventories. For
example, the NRV of a group of inventories held to satisfy a sales contract is based on the
contract price. To the extent that the same entity holds inventory items in excess of those
HKAS required to meet the sales contract, the NRV of the excess inventories is based on the general
2.31 sales price.
Materials and other supplies to be used in the production of inventories are not written
down below cost if the finished goods in which they will be incorporated are expected to be
HKAS sold at an amount at or above cost. However, when the price of the materials decline, indicating
2.32 the finished goods will be sold below cost, such materials are written down to NRV.
At the end of each period, a new assessment of NRV is made. Where a previous
circumstance that caused inventories to be written down to below cost no longer exists or
HKAS there is clear evidence of an increase in NRV, the amount of any previous write-down is
2.33 reversed but only to the extent of the original write down.
Illustrative Example 3
An increase in demand for the newly released COLED televisions has resulted in a decrease
in demand for LCD televisions. VisionCo’s last sale of LCD televisions was at a loss of
HK$1,200 per unit. The decline in the sales price of LCDs is expected to be permanent.
VisionCo undertook a stocktake of its LCD televisions and found that it had 200 units
on hand. The company estimated that the lack of demand for the televisions would require
an extensive sales effort. To encourage its sales team to move the old stock, VisionCo
offered a commission of HK$200 per unit sold.
VisionCo assessed that the NRV (selling price less costs necessary to make the sale) was
HK$1,400 below cost and, therefore, wrote down inventories by HK$280,000 (200 units *
HK$1,400).
Knowledge Check Questions
Question 1
Bits 4 Beach Limited (Bits 4 Beach) is a manufacturer of beach towels and clothing. Due
to a forecasted cooler than average summer, the demand for the company’s products
dropped sharply. Bits 4 Beach responded by significantly reducing the output from its
manufacturing facilities. Determine which one of the following treatments correctly
describes how the company should account for the fixed production overheads during the
period of reduced output.
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Knowledge Check Questions (continued)
A Allocate the idle capacity to the inventories being produced, resulting in an increase in
the cost per item of inventory.
B Write off the idle capacity as an expense in the period in which it is incurred.
C Allocate the idle capacity to the inventories being produced, resulting in a decrease in
the cost per item of inventory.
D Allocate the idle capacity to a separate asset and amortise the cost over the
manufacturing facilities’ useful life.
Question 2
Baths & Suds Limited manufactures component parts for baths. A manager of the
company was provided the following information in relation to production for July 20X2.
Purchase price of materials and supplies HK$600,000
(before rebate)
Supplier rebate HK$60,000
Import duties HK$50,000
Freight inwards HK$25,000
Freight outwards HK$30,000
Direct labour HK$300,000
Variable production overheads HK$40,000
Storage of finished goods (non-essential) HK$10,000
Actual output (July) 20,000 units
Normal capacity (year) 300,000 units
Fixed production overheads (year) HK$1,200,000
Calculate the total cost of inventories manufactured during July 20X2.
Question 3
Lith E Um Limited (Lith E Um) is a retailer of lithium batteries that are used for mobile
telephones and other portable devices. The following information relates to Lith E Um’s
purchases and sales of its line of smartphone batteries for the month of October 20X2.
Date Details No. of units Unit cost Total cost
HK$ HK$
1 October Opening balance 100 250 25,000
11 October Purchased @ HK$270 per unit 200 270 54,000
14 October Sold @ HK$320 per unit 50
19 October Sold @ HK$330 per unit 100
23 October Purchase returns 25
26 October Purchased @ HK$280 per unit 75 280 21,000
Calculate the cost of inventories on hand at 31 October 20X2 using:
• The FIFO cost formula; and
• The weighted average cost formula (updating for every purchase made).
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6 . 3 RECOGNITION AS AN EXPENSE
HKAS
When inventories are sold, the carrying amount of the inventories is recognised as an expense
2.34 in the period in which the related revenue is recognised. The expense is recognised as follows:
Debit Credit
HK$ HK$
Cost of sales x,xxx
Inventories (carrying amounta) x,xxx
HKAS
Write-downs of inventories to NRV and all losses of inventory are recognised as an expense
2.34 in the period in which the write-down or loss occurs (refer to Section 6.2.3, e.g. journal entry).
a
If inventories sold have not been written down to NRV, their cost of sales will be measured at cost. Where inventories
sold were carried at NRV, the cost of sales is reduced by the amount of the previous NRV write-down recognised as an
expense.
Any reversal of a write-down of inventories, arising from an increase in their NRV, is
HKAS
recognised as a reduction in the amount of inventories recognised as an expense in the period
2.34 in which the reversal occurs.
Inventories may be allocated to other assets (for example, when constructing an item of
HKAS
property, plant or equipment). The inventories allocated to another asset are recognised as an
2.35 expense throughout the useful life of the other asset (i.e. depreciation). The journal entry to
allocate the inventories to property, plant and equipment is as follows:
Debit Credit
HK$ HK$
Property, plant and equipment x,xxx
Inventories x,xxx
6 . 4 DISCLOSURE
HKAS 2 requires an entity to make the following disclosures in its financial statements:
• The accounting policies adopted in measuring inventories, including the cost
formula used;
• The total carrying amount of inventories and the carrying amount in classifications
appropriate to the entity;
• The carrying amount of inventories carried at fair value less costs to sell;
• The amount of inventories recognised as an expense during the period;
• The amount of any write-down of inventories recognised at an expense in the period;
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• The amount of any reversal of any write-down that is recognised as a reduction in the
amount of inventories recognised as expense in the period;
• The circumstances or events that led to the reversal of a write-down of inventories; and
HKAS
2.36 • The carrying amount of inventories pledged as security for liabilities.
Information about the carrying amounts on hand and the movements in those carrying
HKAS amounts by classification (e.g. supplies, work in progress and finished goods inventory) is
2.37 useful to users of financial statements.
Inventories recognised as an expense in a period, often referred to as ‘cost of sales’,
consists of:
• The costs previously included in the measurement of inventories that have now
been sold;
• Unallocated production overheads; and
HKAS
2.38 • Abnormal amounts of production costs of inventories.
An entity may present a format of profit or loss that results in amounts being disclosed
other than the cost of inventories. Under this format, an entity classifies expenses by their
HKAS nature, for example, raw materials and consumables, labour costs and other costs together
2.39 with the amount of the net change in inventories for the period.
Illustrative Example 4
VisionCo made the following disclosures related to inventories in its financial statements
for the year ending 31 December 20X3.
X.X Summary of Material Accounting Policy Information (Extract)
X.X(x) Inventories
Inventories are measured at the lower of cost and NRV.
Costs of inventories include the purchase price (net of supplier rebates), import duties
and freight inwards. Inventories are allocated a portion of manufacturing overheads, with
the share of fixed overheads based on the normal operating capacity of manufacturing
facilities. Costs are assigned to inventories using the FIFO cost formula. NRV is the
estimated selling price in the ordinary course of business, less estimated costs of
completion and the estimated costs necessary to make the sale.
...
X Inventories
20X3 20X2
HK$m HK$m
Raw materials (at cost) 1.2 1.4
Work in progress (at lower of cost and NRV) 2.3 2.2
Finished goods (at lower of cost and NRV) 4.8 5.2
Total inventories at lower of cost and NRV 8.3 8.8
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Illustrative Example 4 (continued)
During the year 20X3, the amount of inventories recognised as an expense totalled
HK$7.3 million. In addition, a write-down of HK$0.4 million to NRV was recognised in
respect of finished goods inventories. The write-down was recognised as an expense in
the period.
Inventories with a carrying amount of HK$2.5 million are pledged as security for
VisionCo’s working capital facility.
Knowledge Check Questions
Question 4
During December 20X1, Making A Racquet Limited (Making A Racquet) reassessed the NRV
of its stock of two of its most popular brands of tennis racquet: Keebok and Milson. The
current carrying amounts and revised NRVs of inventories on hand at the end of the period
that were previously written down is as follows:
Keebok Milson
HK$ HK$
Cost 458,000 623,000
Carrying amount – NRV (1/1/20X1) 367,000 587,000
Revised realisable value (31/12/20X1) 422,000 638,000
Required:
(a) Determine the amount of the write-down reversal for each stock of Keebok and
Milson tennis racquets at 31 December 20X1.
(b) Identify whether the reversal of the write-down should be recognised as an item of
income or deducted from an expense.
(c) Evaluate why presenting the reversal of the write-down is appropriate in the
manner discussed in the answer to part (2).
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SUMMARY
• HKAS 2 specifies the accounting for inventories.
• Inventories are measured at the lower of cost and NRV.
• Cost of inventories includes the purchase price, costs of conversion and other
acquisition costs.
• As a simplified method of accounting for inventories, the standard cost method substitutes
expected (standardised) costs for actual costs to measure inventories.
• Where inventories are not ordinarily interchangeable, the cost of inventories is specifically
identified.
• Where inventories are ordinarily interchangeable, the costs of inventories are assigned using
the first-in, first-out method (FIFO) cost formula or weighted average cost formula.
• NRV is the estimated selling price in the ordinary course of business less estimated costs of
completion and estimated costs to make the sale.
• A reversal of a write-down of inventories is recognised as a reduction in the amount of
inventories recognised as an expense in the period in which the reversal occurs.
• When inventories are sold, the carrying amount of those inventories is recognised as an
expense in the same period in which the related revenue is recognised.
• An expense would also have been recognised earlier to the extent of any write-down of those
inventories to net realisable value.
• Required disclosures about inventories include the measurement policies, carrying amounts,
amounts recognised as an expense, write-downs, reversals of write-downs and amounts
pledged as security for liabilities.
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MIND MAP
SCOPE NET REALISABLE VALUE (NRV)
Excludes financial instruments and Estimated selling price in the ordinary
biological assets course of business less estimated costs
Does not apply to the measurement of of completion and estimated costs to
inventories held by make the sale
• Producers of agricultural and forest
products, minerals and mineral products to
the extent measured at NRV in accordance MEASUREMENT
with established practices in those
industries (changes in NRV are recognised) Lower of cost and NRV
in profit or loss); and
• Commodity broker-traders who measure
their inventories at fair value less costs to
sell (changes in fair value less costs INVENTORIES COST
to sell are recognised in profit or loss). (HKAS 2) Purchase (e.g. price, duties)
DISCLOSURE Conversion (e.g. labour, production
overheads)
Following information related to
inventories: measurement accounting Other costs (e.g. non-production
policy, carrying amounts, amounts overheads, specific designs)
recognised as an expense, write-downs, COST FORMULAS
reversal of write-downs and inventories
pledged as security Specific identification
FIFO
EXPENSE
Weighted average cost
When sold
When written down to NRV
Answers to Knowledge Check Questions
Question 1
Answer A is incorrect. HKAS 2 para. 13 requires that the amount of overhead allocated to
inventories does not increase as a result of idle capacity.
Answer B is correct. HKAS 2 para. 13 requires fixed production overheads to be allocated
to costs of conversion on the basis of normal capacity, and for idle capacity to be written
off as an expense in the period in which it is incurred.
Answer C is incorrect. HKAS 2 para. 13 requires that the amount of overhead allocated to
inventories does not increase as a result of idle capacity. Furthermore, the allocation of idle
capacity would result in an increase to the cost of inventories.
Answer D is incorrect. HKAS 2 does not permit the deferral of expenses resulting from
idle capacity.
Question 2
HK$
Cost of materials and supplies 540,000a
Import duties 50,000
Freight inwards 25,000
Direct labour 300,000
Variable production overheads 40,000
Fixed production overheads allocated 80,000 [(1,200,000 ÷ 300,000) * 20,000]
Total cost of inventories 1,035,000
a
Cost (HK$540,000) = Purchase price (HK$600,000) less supplier rebate (HK$60,000).
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Freight outwards and non-essential storage costs are not included in the cost of
inventories because they are not incurred in bringing the inventories to their present
location and condition. Rather, these costs are written off as an expense in the
period incurred.
Question 3
FIFO cost formula
Date Details Purchases Cost of sales Balance
No. Unit Total No. Unit Total No. Unit Total
units cost cost units cost cost units cost cost
HK$ HK$ HK$ HK$ HK$ HK$
1 October Opening
100 250 25,000
balance
11 October Purchased 100 250 25,000
@ HK$270
per unit 200 270 54,000 200 270 54,000
14 October Sold @ 50 250 12,500 50 250 12,500
HK$320
per unit 200 270 54,000
19 October Sold @ 50 250 12,500 150 270 40,500
HK$330
per unit 50 270 13,500
23 October Purchase
(25) 270 (6,750) 125 270 33,750
returns
26 October Purchased 125 270 33,750
@ HK$280
per unit 75 280 21,000 75 280 21,000
Total 250 68,250 150 38,500 54,750
The cost of inventories on hand at 31 October 20X2 is HK$54,750.
Weighted average cost formula
Date Details Purchases Cost of sales Balance
No. Unit Total No. Unit Total No. Unit Total
units cost cost units cost cost units cost cost
HK$ HK$ HK$ HK$ HK$ HK$
1 October Opening
100 250 25,000
balance
11 October Purchased
@ HK$270 200 270 54,000 300 263.33 79,000
per unit
14 October Sold @
HK$320 50 263.33 13,167 250 263.33 65,833
per unit
19 October Sold @
HK$330 100 263.33 26,333 150 263.33 39,500
per unit
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Date Details Purchases Cost of sales Balance
No. Unit Total No. Unit Total No. Unit Total
units cost cost units cost cost units cost cost
HK$ HK$ HK$ HK$ HK$ HK$
23 October Purchase
(25) 270 (6,750) 125 262 32,750
returns
26 October Purchased
@ HK$280 75 280 21,000 200 268.75 53,750
per unit
Total 250 68,250 150 39,500 53,750
The cost of inventories on hand at 31 October 20X2 is HK$53,750.
Question 4
(a) Making A Racquet is required to reverse a previous write-down so the new carrying
amount is the lower of cost and the revised NRV. That is, the reversal is limited to
the value of the original write-down.
• Keebok tennis racquets – the reversal of the previous write-down is equal to
HK$55,000 (422,000 − 367,000).
• Milson tennis racquet − the reversal of the previous write-down is equal to
HK$36,000 (623,000 − 587,000). Because the revised NRV is higher than cost,
the reversal is limited to the original write down.
(b) Making A Racquet must present the reversal of the write-down as a reduction
in the amount of inventories recognised as an expense, rather than as an item
of income.
(c) Making a Racquet may present the reversal of an NRV write-down as a reduction in
an expense, rather than as an item of income, because:
• It is closely linked with an expense. With the benefit of hindsight, it adjusts the
measurement of the impact of a single event, namely, an expected inability
to fully recover the cost of inventory. Therefore, classifying the adjustment in
the same way as the original estimated loss is the most useful presentation
for users of the financial statements of Making a Racquet. If the reversal was
presented as an item of income, users would be likely to group it with inventory
expenses when analysing the financial statements and making predictions
about the entity’s future financial performance.
• It is consistent with the treatment of some other increases in economic
benefits in HKFRSs. For example, under HKAS 37 Provisions, Contingent Liabilities
and Contingent Assets, a third-party reimbursement of an expenditure required
HKAS to settle a provision may be netted against the expense relating to that
37.54 provision in the statement of profit or loss and other comprehensive income.
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Another example is the deduction of the carrying amount of a sold item of
property, plant and equipment and the selling costs from the disposal
proceeds to report a gain (or loss) on disposal rather than reporting the entire
HKAS amount of disposal proceeds as income, in accordance with HKAS 16
16.71 Property, Plant and Equipment.
The treatment of the reversal of a write-down of inventory (being a
reduction in an expense) differs from the treatment of the reversal of
impairment of assets in accordance with HKAS 36 Impairment of Assets. In
accordance with HKAS 36, a reversal of an impairment is recognised as income,
not as a reduction in an expense.
EXAM PRACTICE
QUESTION 1
Light For All Things Limited (Light For All Things) sells light globes to real estate
developers and retail outlets. Light For All Things currently holds 250,000 light globes at
a cost price of HK$10 per unit, determined in accordance with HKAS 2. The company has
a contract with a large real estate developer whereby Light For All Things is obligated to
deliver 150,000 light globes to the developer at a contract price of HK$12 per unit. Due
to an increase in demand for newer, more efficient light globes, as at 31 December 20X4
the current general market selling price for Light For All Things’ light globes has fallen to
HK$9 per unit.
Required:
(a) Advise management on the amount at which Light for All Things should carry its
250,000 light globes. Justify your calculation.
(b) Prepare the disclosure required by HKAS 2 in relation to the 250,000 light globes.
(c) HKAS 2 Para. 7 states that ‘Net realisable value for inventories may not equal fair
value less costs to sell’. Describe the ways in which NRV may differ from fair value less
costs to sell.
QUESTION 2
Fertileyezer, a manufacturer of garden and lawn fertilisers for domestic use,
recently appointed Mary Harkins as Senior Financial Accountant. During Mary’s first
month at Fertileyezer, she has been reviewing the current accounting treatment of
Fertileyezer’s stock.
Mary recovered an accounting memo in relation to the costing of Fertileyezer’s highest
selling product, FertaGreen. FertaGreen is a lawn fertiliser containing purely seaweed extract
and no other additives. Due to the makeup of the product, FertaGreen remains stable for a
relatively short period of time, with a shelf life of six months.
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FertaGreen is manufactured in a dedicated production facility. As of 1 January 20X9,
Fertileyezer had 50,000 units of Fertagreen on hand at a cost of HK$2,800,000. The standard
cost per unit is as follows:
Standard cost
per unit
HK$
Raw materials 30
Freight in 3
Direct labour 6
Variable overheads 4
Fixed overheadsa 15
Storage 3
Total cost 61
a
ixed overheads are allocated using normal capacity. Normal operating capacity allows for 250,000
F
units to be produced each year at a fixed production overhead cost of HK$3.75 million.
For the financial year ended 31 December 20X9, 187,500 units of FertaGreen were produced.
Production was lower than in previous years as a result of an employee strike lasting three
months. The cost of inventories manufactured for the year was determined as follows:
Raw materials HK$30
Freight in HK$3
Direct labour HK$6
Variable overheads HK$4
Fixed overheads HK$20 (HK$3.75 million/187,500)
Storage HK$3
Total cost per unit HK$66
Multiplied by number of units manufactured 187,500
Cost of inventories manufactured HK$12,375,000
As of 31 December 20X9, 90,000 units of FertaGreen were on hand and cost was determined
at the end of the period using the weighted average cost formula as follows:
Units Cost
HK$
Opening balance (01/01/20X9) 50,000 2,800,000
Add cost of goods manufactured 187,500 12,375,000
Costs of goods available for sale 237,500 15,175,000
Weighted average cost per unit 63.89
Less Cost of goods sold 147,500 9,424,474
Closing balance (31/12/20X9) 90,000 5,750,526
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Mary noted that sales had dropped from 190,000 units in 20X8 and was aware of increasing
competition in the industry.
Mary has been advised from management that the company is considering
manufacturing another a new type of high nitrogen fertiliser, HighNitroGreen, in the same
production facility as FertaGreen.
Required:
Produce an accounting memo for management of Fertileyezer advising on any current and
potential issues noted with respect to compliance with HKAS 2 Inventories.
ANSWERS TO EXAM PRACTICE
QUESTION 1
(a) Carrying amount of light globes
Light For All Things must carry its inventory at the lower of cost and NRV. The company
currently holds 250,000 light globes at a cost price of HK$10 per unit, and the current
general market selling price for the light globes is HK$9 per unit. The current level of
stock is in excess of the units required to meet the company’s current sales contract,
under which it is obligated to deliver 150,000 light globes at a contract price of
HK$12 per unit.
HKAS 2 requires that, when estimating NRV, Light For All Things must consider the
purpose for which the inventory is held. Because Light For All Things has a firm sales
contract for 150,000 of its light globes at a sales price that differs from the current
market price, the company must consider the contracted light globes (150,000 units)
separately from the excess stock (100,000 units) when determining the NRV of its
inventories.
For the light globes to be sold under the contract, the NRV is equal to the contracted
sales price (HK$12 per unit). Because the NRV exceeds the cost of the light globes
(HK$10 per unit), the 150,000 units are carried at cost.
The NRV of the excess light globes (100,000 units) is measured at the current
general market selling price of each unit (HK$9 per unit), bearing in mind that the
reduced price reflects technological change rather than a temporary aberration
expected to reverse before the 100,000 excess units are sold. Because the NRV is lower
than cost (HK$10 per unit), the 100,000 units are carried at NRV.
Details Units Cost NRV Total
HK$ HK$ HK$
Contracted sale 150,000 10 1,500,000
Excess inventories 100,000 9 900,000
2,400,000
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(b) Carrying amount and write-down disclosure
X Inventories
20X4 20X3
HK$m HK$m
Finished goods (at cost) 1.5 XX
Finished goods (at NRV) 0.9 XX
Total inventories at lower of cost and net realisable value 2.4 XX
During the year 20X4, a write-down of HK$0.1 million to NRV was recognised in
respect of finished goods inventories. The write-down was recognised as an expense in
the period.
(c) Differences between NRV and fair value less costs to sell
NRV is an entity-specific value, whereas fair value is not. That means the NRV of an item
of inventory will differ from entity to entity. NRV 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. The two values may differ for reasons including:
Net realisable value Fair value less costs to sell
Based on the reporting entity’s selling price Based on the selling price in the principal or
in the ordinary course of business most advantageous market
Based on the purpose for which the Based on the principal or most
inventory is held, e.g. takes into account advantageous market, which uses
contracted sale prices general prices in the relevant market
rather than contracted sale prices with
specific customers
For partly complete inventory, deducts For partly complete inventory, deducts
estimated costs of completion estimated cost of completion and a
market-based profit margin
Takes into account whether a change Reflects the price that would be received to
in general market selling price is likely sell inventories as at the measurement date,
to be temporary, i.e. reverse before the regardless of when sale is expected to occur.
inventories are sold Therefore, whether a price change is likely to
be temporary is irrelevant
QUESTION 2
The question raises several accounting issues within the scope of HKAS 2, including the
measurement of cost, cost formulas and NRV.
Measurement of cost
Fixed production overhead
Due to an employee strike, the production facility remained idle for a period of three
months. The output of the facility (187,500 units) was significantly below normal capacity
(250,000 units), and fixed costs remained unchanged. Fertileyezer has allocated all fixed
production overheads to the 187,500 units produced. Paragraph 13 of HKAS 2 requires that
the amount of fixed production overheads allocated to inventories is not increased as a
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Inventories
result of low production. Accordingly, the excess capacity of HK$937,500 [(250,000 − 187,500)
* HK$15] should be recognised as an expense in the period. Currently the cost of goods sold
and closing balance of inventories is overstated.
Storage costs
Fertileyezer currently includes storage costs in the cost of its Fertagreen inventories. HKAS 2
Para. 16(b) explicitly requires that storage costs are excluded from the costs of inventories,
unless the costs are necessary in the production process before a further production stage.
Not enough information is provided in the case study to determine whether storage is
required in the production process. Mary should request further information regarding
the nature of storage. If storage is not required within the production process, such costs
should be expensed in the period incurred. (The calculations below assume that further
investigation shows the storage costs should not be expensed when incurred.)
Cost formulas
Fertileyezer is currently using the weighted average cost formula to measure the cost
of FertaGreen. The case notes that FertaGreen has a shelf life of six months. Though
the method for physically handling stock is not detailed in the case study, operationally,
Fertileyezer should be managing its stock of FertaGreen on a FIFO basis to minimise
instances of spoilage. Likewise, inventories should be accounted for using the FIFO formula.
Under the FIFO formula, cost of goods sold and the closing balance of inventories would be
calculated as follows:
Units Cost Cost per
unit
HK$ HK$
Opening balance (01/01/20X9) 50,000 2,800,000 56
Add cost of goods manufactured 187,500 11,437,500 61a
Costs of goods available for sale 237,500 14,237,500 –
Less Cost of goods sold 50,000 2,800,000 56
97,500 5,947,500 61
147,500 8,747,500 –
Closing balance (31/12/20X9) 90,000 5,490,000 61
a
ixed manufacturing overheads per unit should be based on normal capacity (i.e. HK$15) rather than
F
unused capacity (i.e. HK$20). Therefore, the total cost per unit manufactured is $61 (refer to Section 6.2.1.1).
Net realisable value
During the period, the stock of FertaGreen has increased from 50,000 to 90,000 units.
As noted in the case, FertaGreen has a shelf life of six months. There may be a need to
write down slow-moving inventories as a result of the limited shelf life. Furthermore, a
decrease in sales occurred due to increased competition in the industry. Fertileyezer needs
to assess whether the cost of FertaGreen inventories exceeds their NRV in accordance with
HKAS 2, particularly paragraphs 9, 28 and 33. The risk that a write-down will be necessary
has increased because of the decline in demand for FertaGreen and the related increase in
stocks nearing the end of their shelf life and becoming potentially obsolete.
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New product
Fertileyezer is considering producing a new product, HighNitroGreen, in the same
production facility as FertaGreen. Currently the production facility is entirely dedicated to
producing FertaGreen.
Fertileyezer should consider how to account for the costs of conversion of FertaGreen
and NitroGreen. If both products are produced simultaneously, separately identifying
the costs of converting each product to finished goods may be impossible. If this is the
case, Fertileyezer must allocate the costs of conversion on a rational and consistent basis
in accordance with HKAS 2 para. 14 (for example, based on the relative sales value of
each product).
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7
Property, Plant
and Equipment
CHAPTER TOPIC LIST
7.1 Overview 7.4.2 Revaluation Model
7.1.1 Scope 7.4.3 Evaluation of the Cost Model
7.1.2 Terminology and the Revaluation Model
7.4.4 Depreciation
7.2 Recognition
7.2.1 Initial Costs 7.5 Derecognition
7.2.2 Subsequent Costs 7.5.1 Transfer of Assets from or to
Property, Plant and Equipment
7.3 Measurement at Recognition
7.3.1 Elements of Cost 7.6 Disclosure
7.3.2 Measurement of Cost
7.4 Measurement after Recognition
7.4.1 Cost Model
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FINANCIAL REPORTING
LEARNING OUTCOMES
PRINCIPAL LO3: EVALUATE AND ADVISE ON APPROPRIATE ACCOUNTING PRINCIPLES TO ACCOUNT
FOR COMPLEX BUSINESS TRANSACTIONS
LO3.04: A
ccount for, evaluate and advise on business transactions in accordance with Hong Kong
Financial Reporting Standards as they relate to: Property, plant and equipment
3.04.01 Describe the non-current assets that fall within or outside the scope of property, plant
and equipment
3.04.02 Apply the recognition criteria in respect of property, plant and equipment
3.04.03 Account for initial measurement of property, plant and equipment, including assets acquired
by exchange or transfer
3.04.04 Account for subsequent expenditure on property, plant and equipment
3.04.05 Describe the available methods to measure property, plant and equipment subsequent to
initial recognition
3.04.06 Account for the revaluation of property, plant and equipment
3.04.07 Apply an appropriate useful life for an asset
3.04.08 Identify the separate significant components and calculate the depreciation amount in
respect of different types of asset
3.04.09 Account for the transfer of properties from or to property, plant and equipment
3.04.10 Account for the disposal of property, plant and equipment
3.04.11 Evaluate the different methods of depreciation: straight line, diminishing balance and units
of production
3.04.12 Evaluate the cost model and revaluation model
3.04.13 Prepare and appraise disclosure in respect of property, plant and equipment
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P roperty, P lant and Eq uipment
OPENING CASE
HI-RISE CRANES
H i-Rise Cranes Limited (HRC) is a Hong Kong–based firm that provides crane services to
the building industry. It has been operating for the past 15 years but is a relatively minor
player in the construction services business.
HRC provides a range of crane-related services including:
• The provision of cranes and drivers for lifting heavy materials and structures, including
in the construction of multi-storey apartment blocks and office buildings;
• The running of a training school for crane drivers; and
• The operation of a repair shop for the servicing of cranes and equipment.
The company started operations in rented premises. It commenced business with one
transport truck and one crane and gradually acquired a fleet of trucks, cranes and other lifting
equipment.
HRC acquired its own freehold premises (an old warehouse site) for office administration
and storing cranes, transport trucks, spare parts and other equipment 10 years ago.
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OVERVIEW
Property, plant and equipment can be described as tangible non-current assets held for
use. They often form a significant part of an entity’s assets, and sometimes are specialised or
adapted for a specialised use within an entity’s operations. They can have a wide variety of
natures or uses.
In this chapter, you will gain an understanding of the nature and types of assets that are
within the scope of HKAS 16 Property, Plant and Equipment, the recognition criteria for items of
property, plant and equipment and how those items are measured at recognition. You will gain
an understanding of how, subsequent to initial recognition, those items may be measured, how
to account for subsequent expenditures on those items, how to account for revaluations of
those items and how to account for the consumption and disposal of those items. Furthermore,
you will gain an understanding of the disclosures about property, plant and equipment that
HKAS 16 requires.
This chapter explores different aspects of accounting for depreciation of property, plant
and equipment. You will gain an understanding of the factors affecting depreciation and
evaluate the different methods of depreciation.
Items of property, plant and equipment can be measured under two different models
(cost and revaluation) after recognition. The measurement basis adopted affects the carrying
amount in the statement of financial position and the measurement of depreciation expense
and the gain or loss recognised when the asset is derecognised upon disposal. In this chapter,
you will gain an understanding of how to evaluate the two measurement models.
In our case study of Hi-Rise Cranes Limited (HRC), its property consists of land, buildings
and improvements to the land, such as fences and parking spaces constructed after acquiring
the land. The term ‘Plant and equipment’ encompasses all the cranes, transport trucks,
temporary safety fencing and other such equipment. It also includes spare parts, tools, office
equipment, computers and furniture.
Throughout this chapter, examples are provided regarding HRC’s property, plant and
equipment and issues that HRC needs to be considered in accounting for those assets, to
provide a practical appreciation of the how the requirements of HKAS 16 are applied (including
how to address the more complex questions that can arise in accounting for property, plant
and equipment).
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P roperty, P lant and Eq uipment
7 . 1 OVERVIEW
This chapter addresses the accounting for property, plant and equipment in accordance with
HKAS 16 Property, Plant and Equipment.
The principal issues in accounting for items of property, plant and equipment are:
• The recognition of those items, including identifying the unit of account for recognition;
• The determination of their carrying amounts, both on initial recognition and
subsequently (including the choice of measurement basis for subsequent
recognition); and
• The determination of depreciation charges and the period over which those charges are
recognised.
Items of property, plant and equipment are subject to the recognition of impairment losses,
whether measured under the cost model or the revaluation model subsequent to initial
recognition. The requirements for the recognition and measurement of those losses are set out
HKAS in HKAS 36 Impairment of Assets; however, disclosure requirements about impairments are also
16.1 set out in HKAS 16.
In this section, you will gain an understanding of the types of assets to which HKAS 16
applies and be introduced to some of the terminology relevant to applying the principles in
that HKFRS.
7.1.1 Scope
HKAS 16 applies in accounting for property, plant and equipment (including spare parts,
stand-by equipment and servicing equipment) except when another standard requires or
allows a different accounting treatment. HKAS 16 does not apply to:
• Property, plant and equipment that is classified as held for sale in accordance with
HKFRS 5 Non-current Assets Held for Sale and Discontinued Operations (see Chapter 15);
• Biological assets related to agricultural activity (under HKAS 41 Agriculture). However,
HKAS 16 applies to bearer plants, excluding the produce of bearer plants (see
Chapter 26);
• The recognition and measurement of exploration and evaluation assets (HKFRS
6 Exploration for and Evaluation of Mineral Resources applies to these assets) (see
Chapter 26); and
• Mineral rights and mineral reserves such as oil, natural gas and similar non-
regenerative resources.
HKAS However, HKAS 16 applies to property, plant and equipment used to develop or maintain
16.2–3 the assets described in (b) to (d).
A lessee’s right-of-use asset under a lease of property, plant and equipment falls within
the scope of HKFRS 16 Leases, not HKAS 16. A right of use does not qualify as a tangible asset
and, therefore, does not meet the definition of ‘property, plant and equipment’ in HKAS 16
(see Section 7.1.2). Nevertheless, under HKFRSs, the right-of-use asset, which may provide
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the same utility as an owned asset, may be presented within classes of property, plant and
equipment because it can provide useful information to present owned and leased assets used
for the same purpose.
7.1.2 Terminology
Before proceeding further, it is necessary to understand what ‘property, plant and equipment’
refers to ‘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; and
HKAS
16.6 • Are expected to be used during more than one period.
Because items of property, plant and equipment are tangible items expected to be used
during multiple periods, they are subject to depreciation.
Depreciation is the systematic allocation of the depreciable amount of an asset over its
useful life. An asset’s depreciable amount is the asset’s cost (or other amount substituted for
cost) less its residual value.
7 . 2 RECOGNITION
HKAS 16 specifies that the cost of an item of property, plant and equipment is recognised as an
asset if, and only if:
• It is probable that future economic benefits associated with that item will flow to the
entity; and
HKAS
16.7 • The item’s cost can be measured reliably.
The cost of an item that fails the criteria for recognition as an asset is recognised as an
expense when incurred.
Generally, the general recognition principle for costs incurred in relation to property, plant
and equipment applies equally to initial and subsequent costs for those assets. However, some
different issues arise in applying that recognition principle to initial and subsequent costs.
These issues are explained in Sections 7.2.1 and 7.2.2.
7.2.1 Initial Costs
Items of property, plant and equipment may be acquired for safety or environmental reasons.
Some may wonder whether it is probable that those items will give rise to future economic
benefits because it may seem that acquiring them does not directly increase the future
economic benefits of any existing item of property, plant and equipment. However, when those
items are necessary for an entity to obtain the future economic benefits from its other assets,
their acquisition secures the amount of future economic benefits derived from those related
HKAS assets. Without them, the future economic benefits of those related assets would be lower.
16.7(a), 11 In such cases the ‘probable future economic benefit’ recognition criterion will be satisfied.
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For example, HRC may be required to purchase strength-testing equipment to comply with
safety requirements imposing limits on lifting certain materials. The equipment is recognised as
an asset because, without it, HRC is unable to sensibly or legally operate its crane business.
7.2.2 Subsequent Costs
Costs related to items of property, plant and equipment incurred after the asset is ready for
use (‘subsequent costs’) are capitalised or recognised immediately as an expense. Capitalisation
may occur either by adding the costs to the carrying amount of the related item of property,
plant and equipment or by recognising a separate asset. The choice between these two
HKAS methods of capitalisation will be a matter of judgement in the circumstances because HKAS 16
16.9 does not specify what constitutes a separate ‘item’ of property, plant and equipment.
Parts of some items of property, plant and equipment may require replacement more
frequently than other parts of those items. For example, the engine and seats of a tourist bus
may require replacement several times during the life of the bus. HKAS 16 adopts a ‘component
approach’ under which different components of an item of property, plant and equipment
(e.g. bus engines and seats) are accounted for as if they were separate items of property, plant
and equipment. The costs of replacing those components are capitalised as part of the item
HKAS when incurred. Later in this chapter, we will see how the component approach is important to
16.13–14 other aspects of accounting for property, plant and equipment (see Section 7.3).
Apply and Analyse 1
In January 20X1, HRC conducted a major repair of its crane equipment by overhauling the
hydraulic system of one of its cranes. HRC’s management expects the repair to enhance
the capacity of the crane to provide services over the next five years. The repair cost
HK$100,000.
At the same time, HRC conducted:
• Routine lubrication on several cranes, at a cost of oils and labour totalling
HK$80,000 per period; and
• Staff training on how to adhere to new safety regulations governing the operation
of cranes, at a cost of HK$50,000.
Identify which of the following three subsequent costs, if any, should be capitalised as
part of the cost of the cranes.
Analysis
The hydraulic system repair cost of HK$100,000 should be capitalised into the repaired
crane because:
• The cost is expected to increase the quantity of outputs that the crane is
expected to produce as it is expected to enhance the capacity of the crane to
provide services;
• The costs will probably generate future economic benefits through enabling the
crane to continue to be operated; and
• The cost can be measured reliably (HK$100,000).
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Apply and Analyse 1 (continued)
The cost of the routine lubrication (HK$80,000) should be recognised as a periodic
expense when incurred because:
• The cost is not expected to increase the quality or quantity of outputs the serviced
cranes are expected to produce, as the capacity of the cranes to provide services is
expected to remain unchanged and, therefore,
• The costs will probably not generate future economic benefits; instead, they are a
cost of operating the cranes in the current period.
The cost of the staff training regarding the operation of cranes (HK$50,000) should be
recognised as an expense when incurred because:
• The cost is expected to assist HRC to operate its cranes more effectively, but is not
expected to enhance the capacity of the cranes to provide services and, therefore,
• The costs will probably not generate future economic benefits from the cranes;
instead, they are a cost of operating the cranes in the current period.
For any capitalised cost, is important to understand the period over which that cost is
expected to generate future economic benefits for the entity. The reason for this is explained in
Section 7.4.4.
Exhibit 7.1 sets out a simplified overview of the treatment of costs incurred, whether
initially or subsequently, in relation to an item of property, plant and equipment (or component
thereof). It does not address subsequent depreciation of capitalised costs, which are discussed
in Section 7.4.4.
Cost is incurred in relation
Probable future
to an item of property,
economic benefits?
plant and equipment NO
Recognise the cost incurred as
YES
an expense immediately
Does the item replace an YES NO
Can the item’s cost be
asset or component
measured reliably?
thereof?
YES NO
Derecognise replaced Is the item distinct NO Capitalise the cost as an
item/component and from an existing
enhancement of that asset
capitalise cost of its asset?
replacement (as a new
asset or new component)
YES
Capitalise cost of new asset
EXHIBIT 7.1 Treatment of costs incurred in relation to an item of property, plant and
equipment (or component thereof)
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The determination of whether a subsequent cost incurred gives rise to probable future
economic benefits will involve judgement about such matters as whether the cost enhances
or maintains the capacity of an existing item of property, plant and equipment. Exhibit 7.1 is
a high-level summary and does not describe all the considerations affecting the decision on
whether to capitalise or expense costs relating to property, plant and equipment.
Knowledge Check Question
Question 1
In relation to an entity’s manufacturing facility that produces cling wrap, apply the
requirements of HKAS 16 to the following costs incurred during the year ending
31 December 20X9, and justify your treatment. Identify any amounts of plant and
equipment, or components thereof, that HKAS 16 requires to be derecognised as
a consequence. Present the accounting entries for these transactions and events.
Accounting entries for depreciation are not required.
A The facility’s baling device was replaced on 30 April 20X9 at a cost of HK$2.5 million. The
carrying amount of the existing baling device that was replaced, as at 30 April 20X9, was
HK$350,000.
B To comply with new legislation, a new anti-pollution filter was installed in the factory
chimney on 1 June 20X9 at a cost of HK$2 million. Installing the anti-pollution filter does
not directly increase the quality or quantity of outputs the other components of the
manufacturing facility are expected to produce. However, its installation is necessary for
continuing to operate the facility and is, therefore, necessary for the entity to obtain the
future economic benefits from those other components of the manufacturing facility.
The filter’s estimated useful life is five years, whereas the remaining useful lives of the
main items of manufacturing equipment range from six years to 12 years.
C A new sorting device was installed on 30 September 20X9 to speed the transportation
of materials in the facility and ease bottlenecks in the production process. Its purchase
price was HK$800,000, and the cost of its installation (including the removal of the
existing sorting device) was HK$30,000. The carrying amount of the replaced sorting
device as at 30 September 20X9 (i.e. immediately before its replacement) was
HK$200,000. Due to unexpected problems arising from the specialised nature of
the complementary assets, the new device was found immediately to be completely
ineffective in enhancing the production process. The new sorting device was scrapped,
and the existing sorting device was reinstalled on 30 September 20X9 at a cost of
HK$25,000.
D Every three years, a mandatory major safety inspection of the facility is performed
by an external party. An inspection was performed on 15 December 20X9 at a cost
of HK$150,000. The previous major inspection was conducted on 18 December 20X6
at a cost of HK$135,000. The entity had capitalised that previous major inspection as
a component of the facility and depreciated it over the three-year period of legally
compliant operation that it enabled. As at 15 December 20X9, the previous inspection
component had been fully depreciated (i.e. the carrying amount was zero).
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7 . 3 MEASUREMENT AT RECOGNITION
HKAS Where an item of property, plant and equipment meets the criteria for recognition as an asset,
16.15 it is measured upon recognition at its cost.
The components comprising the cost of an asset (the ‘elements of cost’) are discussed
in Section 7.3.1. Section 7.3.2 discusses how to measure those components comprising an
asset’s cost.
7.3.1 Elements of Cost
The cost of an item of property, plant and equipment includes:
• Its purchase price;
• Any costs directly attributable to making the asset ready for its intended use
(i.e. bringing the asset to the location and condition necessary for it to be capable of
operating in the manner intended by management); and
• The initial estimate of the cost of extinguishing obligations for dismantling and
removing the asset and restoring the site on which the asset is located when those
obligations are incurred either:
°° Upon acquiring the asset; or
°° Because of using the item during a particular period for purposes other than
producing inventories during that period.
These elements of cost are discussed in Sections 7.3.1.1–7.3.1.3. The same principles are
used to determine the cost of a self-constructed asset as the cost of an acquired asset. If an
entity makes similar assets for sale in the normal course of business as an asset it
HKAS self-constructs as an item of property, plant and equipment, the cost of that item is usually the
16.22 same as the cost of constructing the asset for sale (i.e. as an item of inventory).
7.3.1.1 Purchase Price
An asset’s purchase price includes the cash or cash equivalents (or the fair value of other
consideration) paid to the vendor of that asset to the entity and any import duties and
HKAS non-refundable purchase taxes. The purchase price is calculated after deducting trade
16.16(a) discounts and purchase rebates.
7.3.1.2 Directly Attributable Costs
Costs directly attributable to bringing an asset to the location and condition necessary for it to
be capable of operating in the manner intended by management include:
• Costs of employee benefits arising directly from constructing or acquiring the asset;
• Costs of site preparation;
• Initial delivery and handling costs;
• Installation and assembly costs;
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• Costs of testing whether the asset is functioning properly, where such testing involves
assessing whether the technical and physical performance of the asset is capable of
operating in the intended manner (e.g. being used in the production or supply of goods
or services, for rental to others, or for administrative purposes); and
HKAS
16.17 • Professional fees.
In addition, borrowing costs directly attributable to an asset that necessarily takes a
HKAS substantial period of time to prepare for its intended use (a qualifying asset) must be
16.22 capitalised as part of the asset’s cost, until the asset is substantially ready for use. Chapter 10
discusses when these costs are capitalised and the measurement of the costs.
When an existing structure or other impediment (such as site contamination) needs to be
removed to enable construction of an asset, the removal cost is directly attributable to making
the asset ready for its intended use. This is because the removal cost is necessary incurred in
the asset’s construction and does not relate to acquiring other assets.
Once an asset is ready for its intended use, any further costs incurred in relation to that
asset are not part of the cost of acquiring the asset’s capacity to generate future cash inflows
and, therefore, are not directly attributable costs.
7.3.1.3 Other Costs
In some situations, an entity may acquire or construct an asset knowing that it is obliged to
incur costs to remove the asset (often called ‘make-good’ obligations). For example, an entity
constructs a nuclear research facility and is required by law to decommission the facility upon
HKAS ending research. The obligations for these costs are recognised and measured in accordance
16.18 with HKAS 37 Provisions, Contingent Liabilities and Contingent Assets (see Chapter 18).
However, rather than recognising an expense for these obligations on initial recognition
of the provision, HKAS 16 requires the cost of an item of property, plant and equipment to
include the entity’s initial estimate of the cost of extinguishing obligations for dismantling and
removing that item and restoring the site on which that item is located when those obligations
are incurred either:
• upon acquiring the item; or
• because of using the item during a particular period for purposes other than producing
inventories during that period. For example, where 90% of the eventual costs to
decommission a nuclear research facility arise from constructing the facility and 10%
of those costs arise from conducting research, all of those eventual costs would be
HKAS included in the cost of the facility because none of them were incurred as a result of
16.16(c) producing inventories.
The cost of extinguishing those legal or constructive obligations is a cost necessarily
incurred in acquiring the capacity of the asset to generate future cash inflows. This is because
the entity has no choice but to incur those costs to obtain the asset’s capacity to generate
future cash inflows. Hence, HKAS 16 requires these costs to form part of the cost of the item of
property, plant and equipment.
Changes in an existing make-good obligation (resulting from changes in the estimated
timing or amount of the outflow of resources to settle the obligation or changes in the discount
rate used to measure that obligation) are adjusted against the cost of the related item of
property, plant and equipment in accordance with HK (IFRIC) Interpretation 1 (HK(IFRIC) Int-1)
Changes in Existing Decommissioning, Restoration and Similar Liabilities (see Chapter 18).
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7.3.1.4 Excluded Items
Costs related in some way to an item of property, plant and equipment but are not part of the
item’s purchase price are not directly attributable to making the item ready for its intended
use and do not result from incurring a make-good obligation. The costs are excluded from the
measurement of the item’s cost. Examples of such excluded costs are:
• Costs incurred in using the item;
• Costs incurred in redeploying the item;
• Costs incurred when an item capable of operating as intended by management has yet
to be put to use or is operated at less than full capacity;
• Initial operating losses, such as those incurred when demand for outputs from the
asset builds up;
• Costs of relocating or reorganising part, or all, of the entity’s operations;
• Costs of opening a new facility;
• Costs of introducing a new product or service (e.g. costs of advertising and promotion);
• Costs of conducting business in a new location or with a new class of customer
(e.g. costs of staff training to adjust to the change); and
HKAS
16.19–20 • Administration and other general overheads.
These costs arise from operating assets rather than from acquiring the future economic
benefits embodied in assets and, therefore, are costs of current operations.
In addition, the following items do not form part of the cost of an item of property, plant
and equipment:
HKAS • Costs of abnormal waste (the cost of abnormal amounts of wasted material, labour or
16.22 other resources) and any internal profits;
• Costs and revenues of ‘incidental operations’. Some operations occurring before or
during the construction or development of an item of property, plant and equipment
are not necessary to make the item ready for its intended use. For example, using a
building site as a car park to generate parking fee income until construction
commences is unnecessary to the construction of the building. Because incidental
operations are unnecessary to make an item of property, plant and equipment ready
for its intended use, the income and related expenses arising from incidental
HKAS operations are recognised in profit or loss instead of being included in the
16.21 measurement of the cost of the item of property, plant and equipment; and
• The proceeds from selling items, and the cost of those items, that are produced while
bringing an item of property, plant and equipment to the condition and location
necessary for it to be capable of operating in the intended manner (e.g. samples
produced when testing whether the asset is functioning properly). These proceeds
and costs are recognised in profit or loss (HKAS 16.20A) as they satisfy the definition
of income and expenses, respectively, in the Conceptual Framework for Financial
Reporting and comprise an entity’s financial performance for the reporting period.
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7.3.2 Measurement of Cost
The cost of an item of property, plant and equipment is the cash price equivalent at the
recognition date. This measurement principle is applied to an item of property, plant and
equipment, such as a machine, whether it is acquired through a single payment to a supplier
or through paying separately for multiple components that compose the item (e.g. where the
item is self-constructed). When an item is acquired through paying separately for multiple
components, the measurement principle is applied to each component.
7.3.2.1 Exchange of Assets
One or more items of property, plant and equipment may be exchanged for similar or
dissimilar non-monetary assets, with or without additional monetary consideration provided
by either or both parties to the exchange. (Non-monetary assets are assets other than cash
and amounts receivable in fixed or determinable amounts of money.) These exchanges
might occur to minimise sales commissions and other similar transaction costs, to minimise
transportation costs (e.g. where similar assets in different locations are exchanged) or because
both parties to the transaction have surplus assets they wish to dispose of. For example, HRC
might exchange an item of lifting equipment in one location for a similar item held by another
entity in a different location so both entities can avoid the cost of relocating their item of lifting
equipment.
Except in limited circumstances, the cost of an item of property, plant and equipment
acquired through an exchange of non-monetary assets is measured at fair value, which is
measured in accordance with HKFRS 13 Fair Value Measurement (see Chapter 4). If the fair value
of the asset received or given up can be measured reliably, the fair value of the asset given up
HKAS is used to measure the cost of the asset received unless the fair value of the asset received is
16.26 more evident.
The acquired item is measured at fair value even if the entity cannot immediately
derecognise the asset given up in exchange. Items of property, plant and equipment given up
in exchange for a newly acquired item of property, plant and equipment are derecognised.
Derecognition of items of property, plant and equipment is discussed in Section 7.5.
Exceptions to fair value measurement of such an item occur when the exchange transaction
lacks ‘commercial substance’ or reliable measurement is impossible for the fair value of the
asset received or given up in exchange.
HKAS When either of these circumstances occurs, the cost of the item of property, plant and
16.24 equipment acquired is measured at the carrying amount of the asset given up in exchange.
An exchange transaction has commercial substance if:
• The configuration (risk, timing and amount) of the cash flows of the asset received
differs from the configuration of the cash flows of the transferred asset; or
• The exchange causes a change in the ‘entity-specific value’ of the portion of the entity’s
operations affected by the transaction; and
HKAS • The difference in cash flow configurations or entity-specific value is significant relative
16.25 to the fair value of the assets exchanged.
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An example of an exchange transaction with commercial substance is where HRC
exchanges a used crane plus a cash consideration for another crane company’s used crane with
a higher reach. The crane acquired through the exchange is expected to generate significantly
increased cash inflows compared with the exchanged crane and cause a significant change in
the entity-specific value of HRC’s crane operating business.
Without a commercial substance criterion for measuring the cost of an acquired asset at
its fair value, an exchange of assets with no discernible effect on an entity’s resources (i.e. the
cash-generating capacity of the assets is unchanged) could give rise to a change in the carrying
amounts of assets and a corresponding effect on profit or loss (the IASB was particularly
concerned about the recognition of gains in these circumstances).
Consistent with the general use of a ‘reliable measurement’ criterion for the recognition of
changes in asset and liabilities, HKAS 16 applies a reliable measurement criterion to the use of
HKAS 16.24
HKAS 16
fair value estimates in accounting for exchanges of non-monetary assets. This prevents entities
BC21, BC23 from ‘manufacturing’ gains by attributing inflated values to the assets exchanged.
The fair value of an asset is reliably measurable if the variability in the range of reasonable
fair value measurements is not significant for that asset or the probabilities of the various
estimates within the range of reasonable fair value measurements can be reasonably assessed
and used when measuring fair value.
Key Learning Point
Where an item of property, plant and equipment acquired through an exchange of
non-monetary assets is the fair value of either the asset received or given up can be
measured reliably, the fair value of the asset given up is used to measure the cost of the
asset received unless the fair value of the asset received is more clearly evident.
Apply and Analyse 2
In November 20X3, HRC made a strategic purchase of a parcel of unimproved freehold
land (Land Parcel A) for the purpose of future expansion of its crane operations. The cost
of that land was measured at HK$47.5 million.
In October 20X5, HRC decided to sell Land Parcel A with a carrying amount of
HK$47.5 million and acquire a different parcel of unimproved freehold land in a location
more advantageous to its business. The new parcel of land (Land Parcel B) was expected
to generate a 15% higher return of cash inflows on fair value compared with Land Parcel A.
On 23 December 20X5, an independent valuer assessed the fair value of Land Parcel B at
HK$60 million. The vendor of Land Parcel B wished to acquire Land Parcel A as part of the
transaction.
On 31 December 20X5, HRC entered into a contract to purchase Land Parcel B in
exchange for the following consideration:
• Land Parcel A, the fair value of which was assessed by an independent valuer at
HK$50 million on 27 December 20X5; and
• An immediate cash payment of HK$10 million.
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Apply and Analyse 2 (continued)
In addition, HRC incurred liabilities for the following amounts in respect of its
acquisition of Land Parcel B:
• Stamp duty on purchase: HK$3 million; and
• Legal fees directly associated with the purchase contract: HK$500,000.
On 31 December 20X5, HRC also purchased a partly constructed crane for use as
spare parts. The cash price equivalent of the crane was agreed to be HK$1 million. Under
the contract, HRC agreed to make a cash payment for the crane of HK$1.06 million
on 31 December 20X6. The vendor’s normal credit terms for sales consideration are
settlement within 90 days of contracts being exchanged.
Analyse the information provided to determine how HRC should measure the cost of
Land Parcel B and the crane. Determine the accounting entries HRC should make as of
31 December 20X5 in relation to the two acquisitions in accordance with HKAS 16 and the
entries for the year ended 31 December 20X6 in relation to the financing of the crane’s
acquisition.
Analysis
In determining the cost of Land Parcel B acquired on 31 December 20X5, HRC applies the
measurement principles in HKAS 16 to each component of the consideration it provided,
as follows:
• HRC applies the principle in HKAS 16 that the cost of an item of property, plant and
equipment acquired in an exchange for monetary and non-monetary consideration
is measured at fair value unless the exchange transaction lacks commercial
substance or the fair value of neither the asset received nor the asset given up is
reliably measurable.
°° Therefore, the exchange transaction has commercial substance because the
new parcel of land was expected to generate a 15% higher return of cash
inflows on fair value compared with the existing parcel of unimproved land.
The entity-specific portion of the entity’s operations affected by the transaction
is expected to change to a significant extent compared with the fair value of the
assets exchanged.
°° The fair values of the asset received and the asset given up are reliably measurable.
°° For these reasons, the cost of HRC’s new parcel of unimproved land is
measured at its fair value, subject to adding any other components of that
asset’s cost.
• The fair value of the unimproved land acquired is HK$60 million. This equals the
sum of the fair value of the asset given up in exchange (HK$50 million) and the
cash component of HRC’s consideration (HK$10 million).
• The cost of HRC’s new parcel of unimproved land also includes:
°° The cash amount of the stamp duty (HK$3 million) because HKAS 16 identifies
non-refundable purchase taxes as part of the purchase price of an item of
property, plant and equipment; and
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Apply and Analyse 2 (continued)
°° The cash amount of the legal fees (HK$500,000) because HKAS 16 identifies
professional fees as costs directly attributable to acquiring an item of property,
plant and equipment.
Therefore, the cost of HRC’s new parcel of unimproved land is HK$63.5 million.
The fair value of the consideration given and received in the exchange of assets was
HK$60 million. A gain of HK$2.5 million arose from the initial recognition of Land Parcel B
and derecognition of Land Parcel A because Land Parcel A had a fair value of HK$50 million
but a carrying amount of HK$47.5 million.
In determining the cost of the crane it acquired on 31 December 20X5, HRC
observes that:
• HKAS 16 requires the cost of an item of property, plant and equipment to be
measured at the item’s cash price equivalent. Therefore, the cost of the crane is its
cash price equivalent of HK$1 million; and
• Its scheduled payment for the crane is deferred beyond normal credit terms.
Therefore, in accordance with HKAS 16, the difference between the cash price
equivalent (HK$1 million) and the total payment (HK$1.06 million) is recognised as
interest over the 12-month period of credit (i.e. HK$60,000 is recognised as interest
expense during the year ending 31 December 20X6).
The accounting entries for the acquisitions on 31 December 20X5 and the financing of
the crane’s acquisition during the year ending 31 December 20X6 are:
As at 31 December 20X5
Debit Credit
HK$m HK$m
Land Parcel B 63.5
Land Parcel A 47.5
Cash 10.0
Stamp duty payable 3.0
Legal fees payable 0.5
Gain on exchange of land parcels 2.5
(Recognition of exchange of Land Parcels A and B and the related
gain, together with accrual of liabilities arising from the acquisition of
Land Parcel B)
Debit Credit
HK$m HK$m
Cranes 1.0
Loans 1.0
(Recognition of acquisition of crane and related loan from vendor)
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Apply and Analyse 2 (continued)
For the year ending 31 December 20X6 (cumulative entry)
Debit Credit
HK$m HK$m
Interest expense 0.06
Loans 0.06
(Recognition of interest accrued on HK$1 million loan from vendor of crane)
As at 31 December 20X6
Debit Credit
HK$m HK$m
Loans 1.06
Cash 1.06
(Extinguishment of loan for crane)
Knowledge Check Questions
Question 2
Identify which one of the following statements is not true under HKAS 16.
A The cost of an item of property, plant and equipment is measured at the item’s cash
price equivalent if, and only if, payment for the item is deferred beyond normal
credit terms.
B In principle, the cost of an item of property, plant and equipment is measured at its fair
value at its date of recognition if the entity pays non-monetary asset(s) as consideration
(i.e. an exchange of non-monetary assets occurs).
C Where an item of property, plant and equipment is acquired through an exchange of
non-monetary assets, the cost of that item is measured at its fair value at its date of
recognition unless:
• The exchange transaction lacks commercial substance; or
• The fair value of neither the asset received nor the asset given up is reliably
measurable.
D Where an item of property, plant and equipment is acquired through an exchange
of non-monetary assets, if the exchange fails either of the criteria for measuring the
acquired item’s cost at its fair value, the cost of the acquired item is measured at the
carrying amount of the asset given up in exchange.
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Knowledge Check Questions (continued)
Question 3
Identify which one of the following statements is not true in respect of using fair value
to measure the cost of an item of property, plant and equipment acquired through an
exchange of non-monetary assets.
A The fair value of an asset is reliably measurable if the variability in the range of
reasonable fair value measurements is insignificant for that asset.
B Even if the variability in the range of reasonable fair value measurements for an asset is
significant, the asset’s fair value is reliably measurable if the probabilities of the various
estimates within the range can be reasonably assessed and used when measuring fair value.
C If the fair value of the asset received or given up can be measured reliably, the fair value
of the asset received is used to measure the cost of the asset received unless the fair
value of the asset given up is more clearly evident.
D Requiring fair value estimates to satisfy a reliable measurement criterion for use
in accounting for exchanges of non-monetary assets prevents entities from
‘manufacturing’ gains.
7 . 4 MEASUREMENT AFTER RECOGNITION
After the initial recognition as an asset, an item of property, plant and equipment is measured
HKAS using the cost model or revaluation model. That accounting policy choice must be applied
16.29 consistently to each asset in a class of property, plant and equipment. A class of property, plant
HKAS and equipment is a grouping of assets of a similar nature and use in an entity’s operations
16.37 (e.g. land, machinery, motor vehicles, office equipment). The cost model and revaluation model
are explained in Sections 7.4.1 and 7.4.2, respectively. Those models are evaluated in Section 7.4.3.
7.4.1 Cost Model
Under the cost model, an item of property, plant and equipment is carried at the amount
depicted in Exhibit 7.2.
Cost (see Section 3.2)
minus
Any accumulated depreciation (see Section 4.4)
minus
Any accumulated impairment losses (see Chapter 14)
EXHIBIT 7.2 Measurement of the carrying
amount of an item of property, plant and
equipment under the cost model
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7.4.2 Revaluation Model
Under the revaluation model, after recognising an item of property, plant and equipment as an
asset, that item is carried at a revalued amount if its fair value can be measured reliably. The
measurement of an item’s revalued amount is depicted in Exhibit 7.3.
Fair value (determined in accordance with HKFRS 13
Fair Value Measurement) at the date of revaluation
minus
Any subsequent accumulated depreciation
minus
Any subsequent accumulated impairment losses
EXHIBIT 7.3 Measurement of the revalued
amount of an item of property, plant and
equipment
If an item of property, plant and equipment is revalued, the entire class of assets to which it
HKAS 16.31
belongs must be revalued. Revaluations must be regularly made to ensure the item’s carrying
and .36 amount does not differ materially from its fair value at the end of the reporting period.
Classes of assets may be revalued on a rolling basis (e.g. spreading the revaluation of assets
in different geographical regions over a period) provided revaluation of the class is completed
within a short period and the revaluations are kept up to date. This enables a strategic
approach to revalue a large number or widely dispersed set of assets forming a single class.
HKAS The assets can be systematically revalued over time without undue cost or effort while ensuring
16.38 the fair values of revalued assets are not materially misstated.
When an item of property, plant and equipment is revalued, the entity has an accounting
policy choice to use either of the following methods to adjust that asset’s carrying amount to its
revalued amount:
• Adjusting the gross carrying amount (i.e. the amount before deducting accumulated
depreciation and accumulated impairment losses) in a manner consistent with the
revaluation of the asset’s carrying amount (see the following elaboration); or
• Eliminating the existing balance of accumulated depreciation against the gross carrying
amount of the asset.
To adjust an asset’s gross carrying amount in a manner consistent with the revaluation of
that asset’s carrying amount, the gross carrying amount may, for example, be restated by
reference to observable market data or restated proportionately to the change in the carrying
amount. The accumulated depreciation at the revaluation date is adjusted to equal the
HKAS difference between the gross carrying amount and the carrying amount of the asset after
16.35 accounting for accumulated impairment losses.
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Under either method of adjusting a revalued asset’s carrying amount to its revalued
HKAS amount, the amount by which accumulated depreciation is adjusted forms part of the increase
16.35 or decrease in carrying amount that is accounted for in the entries shown below.
As previously mentioned, revaluations of items of property, plant and equipment are
HKAS performed on a whole-of-class basis. However, the accounting entries for recognising an
16.39–40 upwards or downwards revaluation are determined on an asset-by-asset basis.
The accounting entries for a revaluation of an item of property, plant and equipment in
accordance with HKAS 16 are set out below:
If there was a revaluation increase: general rule
Debit Credit
HK$ HK$
Property, plant and equipmenta XXX
Revaluation surplus (other comprehensive income) XXX
a
If the asset’s carrying amount is restated by adjusting the gross carrying amount and the
accumulated depreciation, an additional entry would be made to the accumulated depreciation
account. This is illustrated in the Apply and Analyse in this section. However, that aspect has no
bearing on determining when a revaluation of an item of property, plant and equipment gives rise
to an entry in profit or loss or other comprehensive income.
If there was a revaluation increase: exception
This exception arises if a revaluation increase reverses (wholly or partially) a revaluation
decrease of the same asset previously recognised in profit or loss. Its treatment is illustrated in
the following example.
If a revaluation decrease of HK$35,000 had previously been recognised as a loss in respect
of an item of property, plant and equipment, and in the current period, a revaluation increase
of HK$50,000 was recognised in respect of that asset, the following accounting entry would be
made in the current period:
Debit Credit
HK$ HK$
Property, plant and equipment 50,000
Revaluation gain (profit or loss) 35,000
Revaluation surplus (other comprehensive income) 15,000
If there was a revaluation decrease: general rule
Debit Credit
HK$ HK$
Revaluation loss (profit or loss) XXX
Property, plant and equipment XXX
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If there was a revaluation decrease: exception
This exception arises if a revaluation decrease is recognised and a credit balance exists in the
revaluation surplus (within equity) in respect of the same asset. Its treatment is illustrated in
the following example:
Assume that a revaluation increase of HK$60,000 was previously credited to revaluation
surplus in respect of an item of property, plant and equipment and has not been transferred
out of that account within equity (e.g. to retained earnings). Assume also that a revaluation
decrease of HK$90,000 is recognised in respect of that asset during the current period. The
following accounting entry would be made in the current period:
Debit Credit
HK$ HK$
Revaluation surplus (other comprehensive income) 60,000
Revaluation loss (profit or loss) 30,000
Property, plant and equipment 90,000
Key Learning Point
A revaluation gain is recognised in other comprehensive income to the extent it does not
reverse existing net revaluation losses (if applicable). A revaluation loss is recognised in
profit or loss to the extent it does not reverse existing net revaluation gains (if applicable).
The balance of revaluation surplus included in equity in respect of a revalued item of
property, plant and equipment may be transferred directly to retained earnings (i.e. not
through profit or loss) for the following reasons:
• The asset is used by the entity in the amount of the periodic difference between
depreciation based on the asset’s revalued carrying amount and depreciation based on
the asset’s original cost (see Section 7.4.4 for discussion of depreciation and an example
of how revaluations affect the measurement of depreciation); and/or
HKAS
16.41 • When the asset is derecognised.
HKAS HKAS 36 Impairment of Assets requires any impairment loss of a revalued item of property,
36.60 plant and equipment to be treated as a revaluation decrease in accordance with HKAS 16.
HKAS HKAS 36 states that a reversal of an impairment loss of a revalued item of property, plant and
36.119 equipment is treated as a revaluation increase in accordance with HKAS 16. An illustration of
applying the revaluation model is provided at the end of Section 7.4.4 on depreciation, showing
the interaction between accounting for revaluations and related depreciation and
impairment losses.
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Apply and Analyse 3
On 1 January 20X5, HRC purchased a specialised item of imported lifting equipment for a
cost of HK$850, 000. As of 31 December 20X5, HRC revalued the same class of equipment
to fair value. The fair value of the specialised item was measured using the cost approach,
with the equipment’s fair value measured at current replacement cost. The new asset price
and estimated residual value of that equipment had increased by 10% during the year,
and obsolescence included in the current replacement cost was confined to the effects of
depreciation. Thus, the new asset’s price on 31 December 20X5 was HK$935,000, and its
fair value was HK$825,000 after deducting ‘obsolescence’ (i.e. depreciation) of HK$110,000.
Immediately before recognising the revaluation, the carrying amount of HRC’s item
of equipment was HK$750,000 (calculated as its cost of HK$850,000 minus accumulated
depreciation of HK$100,000). (How accumulated depreciation is determined is discussed in
Section 7.4.4. In relation to the fact pattern in this example, the calculation of depreciation
on the revalued item of equipment is demonstrated in the extension of this example at the
end of Section 7.4.4.)
Required
Account for the revaluation of HRC’s specialised item of imported lifting equipment as of
31 December 20X5 under each of the two following methods in HKAS 16, by presenting the
accounting entries for those methods:
• Restate the gross carrying amount by reference to observable market
data and proportionately adjusting the accumulated depreciation at the
revaluation date; and
• Eliminate the existing balance of accumulated depreciation against the gross
carrying amount of the asset.
In addition, present a tabular comparison of the balance of each account after
recognising the revaluation under the two methods.
Analysis
Accounting entries as at 31 December 20X5
Restating the gross carrying amount by reference to observable market data and
proportionately adjusting the accumulated depreciation at the revaluation date:
Debit Credit
HK$’000 HK$’000
Equipment 85
Accumulated depreciation – equipment 10
Revaluation surplus (other comprehensive income) 75
(Recognition of revaluation of asset from HK$750,000 carrying amount to fair value of
HK$825,000)
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Apply and Analyse 3 (continued)
Eliminating the existing balance of accumulated depreciation against the gross carrying
amount of the asset:
Debit Credit
HK$ HK$
Accumulated depreciation – equipment 100
Equipment 100
Equipment 75
Revaluation surplus (other comprehensive income) 75
(Recognition of revaluation of asset from HK$750,000 carrying amount to fair value of
HK$825,000)
Comparison
Asset account Restating the gross Eliminating accumulated
carrying amount depreciation against the
and accumulated asset’s gross carrying
accumulation amount
HK$‘000 HK$‘000
Gross carrying amount 935 825
Accumulated depreciation (110) 0
Carrying amount 825 825
7.4.3 Evaluation of the Cost Model and the Revaluation Model
An evaluation of the cost model for subsequent measurement of property, plant and
equipment is set out in Section 7.4.3.1. An evaluation of the revaluation model for subsequent
measurement of property, plant and equipment is set out in Section 7.4.3.2.
7.4.3.1 Cost Model
Under the cost model, assets are carried at amounts based primarily on prices in actual
transactions in which they were acquired. Some see this as important because:
• It enables assessments of returns on the amounts originally invested in those assets,
for example, by comparing revenues with depreciation measured on the basis of
original cost (revaluation increases the results in lifetime depreciation charges for an
asset that exceed the asset’s historical acquisition cost); and
• Some would argue that it is less subjective than other measurement bases, such as
fair value.
When assets are measured using the cost model, the assets are expected to generate
economic benefits that will at least recover their carrying amounts. Some see this as important
because they are more concerned about potential overstatement of assets than their potential
understatement.
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Applying the cost model can entail estimation uncertainty because judgements
about uncertain future events are necessary when calculating depreciation (i.e. in
estimating the asset’s useful life and pattern of consumption) and estimating an asset’s
recoverable amount.
In addition, when different assets (or different components of complex assets) measured
under the cost model are acquired at different times when different price levels apply,
understanding the economic significance of asset totals can be difficult. For example, the cost
of pollution abatement plant installed during the current period might be added to the cost of a
factory built 50 years earlier.
An advantage to entities of applying the cost model is that it tends to be less expensive
to apply than the revaluation model because it does not involve obtaining regular valuations
of assets.
7.4.3.2 Revaluation Model
An asset’s fair value reflects market participants’ current expectations about the amount, timing
and uncertainty of future cash flows the asset will generate (either on a stand-alone basis or
in combination with other assets). Some see this information as important because assets
are held to generate net cash inflows, and measures reflecting current expectations about
those cash flows arguably provide superior information (compared with historical cost-based
measures) to users for making their own predictions of the future cash flows those assets
will generate.
For example, some note that expenses incurred by consuming those assets will be
measured using current prices and, thus, can be compared with revenues generated by using
those assets (which are measured using current prices). Further, when measuring property,
plant and equipment at current replacement cost (see Chapter 4 for elaboration), fair value
measurements provide information more useful than historical cost-based measurements for
predicting cash outflows needed to replace those assets.
Some observe that many types of property, plant and equipment tend to have long useful
lives and consequently, price changes tend to be more significant for those assets than for
other types of assets, such an inventory, that tend to be held for a short period.
Some entities may be concerned that, under the revaluation model, revaluation increases:
• Are normally credited to equity outside profit or loss (see the following text in this
section), but result in increased depreciation charges recognised in profit or loss; and
• Result in lower reported returns on assets and equity.
Measurements under the revaluation model are subject to estimation uncertainty
because the fair value of some assets might not be directly observable and may require
estimates that are:
• Based on limited market data, due to (for example) the assets being specialised and/or
traded in markets with a wide dispersion of prices; or
• Based on estimates of future cash inflows the asset will generate.
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7.4.4 Depreciation
The general requirements of HKAS 16 for depreciation of property, plant and equipment are
discussed in Section 7.4.4.1. Section 7.4.4.2 discusses more specific aspects of accounting
for depreciation (namely, determining an item’s residual value, useful life and depreciation
method), and Section 7.4.4 discusses depreciation of components of assets.
7.4.4.1 General Requirements
An entity is required to recognise depreciation of its property, plant and equipment, which is
the systematic allocation of the depreciable amount of an asset over its useful life. An asset’s
HKAS
depreciable amount is its cost or other amount substituted for cost (e.g. revalued carrying
16.6, 50 amount), less its residual value.
Each item of property, plant and equipment must be depreciated over its useful life except
for some holdings of freehold land. Freehold land typically has an unlimited useful life and,
therefore, typically is not depreciated. However, in some instances, freehold land has a limited
HKAS useful life or the cost of land includes amounts that require depreciation, explained later in this
16.52 section. Repairs and maintenance of an asset do not obviate the need to depreciate that asset.
Most land holdings in Hong Kong are leasehold property (see Chapter 9).
Depreciation is accounted for separately for each part of an item of property, plant and
equipment with a cost significant in relation to the total cost of the item. For example, a tourist
coach might comprise of three significant components, being the engine, air conditioning
system and passenger seats. Each component is depreciated separately over their respective
useful lives. However, different parts of the same item of property, plant and equipment may
be grouped for depreciation purposes if they have the same useful life and the same
depreciation method is applied to them. For example, the engine and transmission of a tourist
coach may be required to be replaced at the same time and, therefore, may be grouped for
HKAS depreciation purposes. Individually insignificant parts of an item of property, plant and
16.43–47 equipment may be depreciated separately.
Key Learning Point
An entity depreciates separately each part of an item of property, plant and equipment
with a cost that is significant in relation to total cost of the item.
Depreciation of an asset commences when the asset is in the location and condition
necessary for it to be capable of operating in the manner intended by management.
Depreciation of an asset ceases at the earlier of when the asset is held for sale in accordance
with HKFRS 5 Non-current Assets Held for Sale and Discontinued Operations (see Chapter 15) and
when the asset is derecognised. Depreciation does not cease while an asset is idle or retired
from active use unless the asset is fully depreciated. However, in those circumstances the
HKAS
depreciation charge can be zero when no production is occurring if a usage method of
16.55 depreciation is applied to the asset.
HKAS
The depreciation charge for each period is recognised in profit or loss unless that charge is
16.48 included in the carrying amount of another asset.
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Sometimes, the future economic benefits embodied in an asset are absorbed in producing
other assets, such as in converting raw materials into inventories, in self-constructing an item of
plant, or in carrying on development activities that lead to the recognition of an intangible
HKAS asset. Where this occurs, the depreciation charge constitutes part of the cost of the other asset
16.49 and is included in that other asset’s carrying amount.
Illustrative Example 1
Multiform Limited (Multiform) uses a machine to produce inventories and to produce
spare parts for other items of property, plant and equipment. The depreciation charge
for the machine for the current period was calculated as HK$500,000. Of that amount:
• HK$350,000 was directly attributable to the production of inventories;
• HK$125,000 was directly attributable to the production of spare parts; and
• HK$25,000 was abnormal waste, resulting from defects in some materials supplied
to Multiform and, therefore, not capitalised into the cost of another asset.
The accounting entry to record the depreciation of the machine for the period is
as follows:
Debit Credit
HK$ HK$
Inventories 350,000
Spare parts 125,000
Depreciation expense – machine (profit or loss) 25,000
Accumulated depreciation – machine 500,000
HKAS Compensation from third parties for assets that were impaired, lost or given up is
16.65 recognised in profit or loss when the compensation becomes receivable.
7.4.4.2 More Specific Aspects of Accounting for Depreciation
To calculate the depreciation for an asset (or a component of a larger asset), an entity needs
to estimate the asset’s (component’s) depreciable amount (which includes estimating its
residual value) and its useful life and must determine the appropriate method of depreciation.
Estimates of an asset’s (component’s) useful life involve judgements about uncertain future
events. These aspects are discussed in the following text.
Residual Value
An asset’s residual value is deducted in the determination of the asset’s depreciable amount.
Residual value is the estimated amount that an entity would currently obtain from disposal of
HKAS the asset after deducting the estimated costs of disposal, if the asset were already of the age
16.6 and in the condition expected at the end of its useful life. For example, an entity holds a
building with a cost of HK$25 million and useful life of 40 years. Based on direct market
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comparison, the current disposal value of an almost identical building that is 40 years old is
estimated as HK$5 million. The entity expects that, due to increasing demand for buildings, the
disposal value of the building at the end of its useful life will exceed its cost of HK$25 million.
Nevertheless, this does not mean the building has a depreciable amount of zero: The building’s
residual value is measured at HK$5 million and its depreciable amount is, therefore,
HK$20 million.
Because residual value is determined by reference to the net amount currently obtainable
from an asset’s disposal, the existence of a depreciable amount is not nullified by expected
future increases in the asset’s disposal price. Nevertheless, an asset’s residual value might
increase to an amount equalling or exceeding the asset’s carrying amount. In such a case, the
asset’s depreciation charge is zero unless and until its residual value subsequently decreases to
an amount less than the asset’s carrying amount. Where an asset’s fair value exceeds its
HKAS carrying amount but its residual value is less than its carrying amount, it is still necessary to
16.52, 54 recognise depreciation. This reflects the entity-specific nature of residual value.
Useful Life
Depending on the circumstances, an asset’s useful life might be measured in terms of units of
production or time. Hence, HKAS 16 defines ‘useful life’ as:
• The period over which an asset is expected to be available for use by an entity; or
• The number of production or similar units expected to be obtained from the asset by
an entity.
The future economic benefits embodied in an item of property, plant and equipment
are consumed principally through using that item. However, other factors can also cause
diminution of those future economic benefits. Therefore, all the following factors are
considered in determining an asset’s useful life:
• The asset’s expected usage, assessed by reference to the asset’s expected capacity or
physical outputs;
• Expected wear and tear, which depends on the intensity of use of the asset, the repairs
and maintenance programme and maintenance of the asset while idle (physical
deterioration can occur even while an asset is idle);
• Technical or commercial obsolescence arising from improvements or other changes in
production, or from a change in market demand for the asset’s outputs; and
HKAS
16.56 • Legal or similar limits on the asset’s period of use, such as expiry dates of related leases.
The most important factor is the one that causes an asset’s useful life to expire the soonest.
The useful life of an asset accounts for the asset’s expected usage by the entity, which is an
entity-specific factor. An entity’s asset management policy might, for example, involve disposing
of assets after a specified time (e.g. where travelling sales staff are provided with a new car
every four years as part of their conditions of employment although the cars could provide
HKAS reliable service for many more years) or after consumption of a specified proportion of the
16.57 asset’s output capacity. Therefore, an asset’s useful life might be shorter than its economic life.
As mentioned earlier in this section, land typically has an unlimited useful life and,
therefore, typically is not depreciated. However, some land holdings, such as quarries, landfill
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sites and land parcels exposed to coastal erosion, have a limited useful life and, therefore, are
depreciated. In addition, the cost of some land holdings includes the costs of site
HKAS dismantlement, removal and restoration. That portion of the land’s cost is depreciated over the
16.58–59 period of benefits obtained by incurring those costs.
Apply and Analyse 4
On 1 January 20X1, Multiform purchased an item of machinery. The machine is estimated
to be capable of producing 100,000 units of output before needing replacement. Multiform
intends to use the machine for the next four years and estimates it will produce 70,000
units in that time. Determine an appropriate useful life over which Multiform should
depreciate the machine.
Analysis
The useful life of an asset may be shorter than its economic life because an entity intends
to use the asset for that shorter period. This is the case with Multiform, which expects to
use the machine for a shorter period than the one during which it is expected to remain
capable of producing outputs. Therefore, the machine’s period of expected use is more
relevant to estimating its useful life than its capacity to produce outputs. The machine’s
useful life should be four years.
Depreciation Method
The depreciation method used to recognise depreciation depicts the pattern of consumption
of the future economic benefits embodied in the asset over the asset’s useful life. Various
depreciation methods can be used to allocate an asset’s depreciable amount on a systematic
basis over its useful life, including time-based methods, which include:
• the straight-line method, which results in a constant charge over the asset’s useful life if
neither the asset’s useful life nor residual value are adjusted;
• the diminishing balance method, which results in decreasing charges over the asset’s
useful life; and
• the units of production method, which results in a charge based on the asset’s expected
use or outputs.
HKAS It is inappropriate to apply a depreciation method based on revenue generated by an
16.62–62A activity in which the asset is used.
The depreciation method chosen for a particular asset is:
• That which most closely reflects the expected pattern of consumption of the future
economic benefits embodied in the asset; and
• Applied consistently from period to period unless and until there is a change in the
expected pattern of consumption of those future economic benefits.
Choosing the most appropriate depreciation method will depend on the circumstances of
each asset. Exhibit 7.4 sets out considerations relevant to choosing among the three methods.
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Method When the method Examples of when, or circumstances
is appropriate in in which, the method is appropriate
principle
Straight line The asset’s future This may be the case for:
economic benefits are • general purpose buildings, and office furniture
expected to be consumed and fittings, which tend not to have variable use
in an even pattern over over time; and
its useful life
• assets (such as exposed metal structures in seaside
locations) with useful lives determined primarily
by weathering over time, regardless of their
intensity of use.
Diminishing The asset’s future This might be considered appropriate for assets with
balance economic benefits are superior performance during their early years of use,
expected to be consumed such as those:
at a faster rate during • with increasing maintenance costs over their
the earlier periods of its useful lives
useful life
• with more interruptions to use (planned or
unplanned) during their later years
• prone to technical or commercial obsolescence
because their capacity to help the entity remain
competitive is likely to diminish over time. If
an asset becomes technologically outdated
but remains serviceable as a standby asset, its
useful life will include its forecast period of use
as a standby asset (e.g. this might occur for
power generators and computers). Applying
the diminishing balance method (with its higher
depreciation charges in earlier years) might be
considered to faithfully represent the asset’s
diminished contribution during its use as a
standby asset.
Units of The asset’s future This relationship is often found where an asset’s
production economic benefits are useful life is:
consumed in proportion • limited to roughly a certain number of units of
to the number of units output and hours of operation, and
of output produced by
• affected significantly by wear and tear (e.g. aircraft
the asset, or number
engines and road surfacing, which deteriorate
of hours of operation,
mostly accordingly to the number of heavy vehicles
during the period
travelling over it, tend to be consumed more
according to use than time).
Where an asset’s useful life is determined primarily
by the number of production units, it is particularly
important to use this method of depreciation if the rate
of the asset’s use varies significantly over time.
EXHIBIT 7.4 Methods of depreciation compared
Apply and Analyse 5
HRC acquired a machine on 1 January 20X1 and expects to use it for the next five years.
HRC is considering which depreciation method it should apply. The machine is expected
to be more efficient in years one and two; subsequently, the machine’s performance is
expected to continually decrease over time.
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Apply and Analyse 5 (continued)
Determine an appropriate method of depreciation for the machine, based on this
information. In your response, explain why other methods are less appropriate.
Analysis
On balance, the diminishing balance method is the most appropriate method of
depreciation for HRC’s machine. This is because, under that method, higher depreciation
charges are recognised in the periods in which the greatest benefits are derived from
the machine (which are the early years of the machine’s useful life). A weakness of that
method is that it would charge a higher amount in year one than in year two although the
machine’s efficiency is not expected to decline until after the second year.
There is insufficient information to support applying the units of production method
of depreciation to the machine. If the decline in the machine’s efficiency over time
were to be accompanied by a declining number of units of output, applying the units of
production method would result in higher depreciation charges in the first two years than
in the later years of the machine’s useful life (which would be similar to the diminishing
balance method but avoid the weakness of that method previously mentioned). However,
that is not stated in the fact pattern. In addition, it is not stated that the machine’s
useful life is determined primarily by the number of production units. Therefore, the
units of production method of depreciation are less appropriate than the diminishing
balance method.
The straight-line method of depreciation is inappropriate for HRC’s machine because
that method is appropriate when an asset’s future economic benefits are expected to be
consumed in an even pattern over its useful life. In contrast, the performance of HRC’s
machine is expected to decrease over time.
Apply and Analyse 6
This Apply and Analyse builds on the Apply and Analyse in Section 7.4.2. It includes the
calculation of depreciation under the cost and revaluation models. Therefore, some
repetition of facts exists from that earlier Apply and Analyse.
On 1 January 20X5, HRC purchased a specialised item of imported lifting equipment
for a cost of HK$850, 000. The equipment’s estimated useful life was eight years, and
the estimated residual value was HK$50,000. HRC uses the straight-line method of
depreciation for the equipment.
As of 31 December 20X5, HRC revalued the same class of equipment to fair value.
The fair value of the specialised item was measured using the cost approach, with the
equipment’s fair value measured at current replacement cost. The new asset price and
estimated residual value of that equipment had increased by 10% during the year, and
obsolescence included in the current replacement cost was confined to the effects of
depreciation. Thus, the new asset’s price at 31 December 20X5 was HK$935,000, and its
fair value was HK$825,000 after deducting ‘obsolescence’ (i.e. depreciation for the year
restated for the changes in the asset price and residual value) of HK$110,000 (calculated
as: (new asset cost of HK$935,000 minus residual value of HK$55,000) ÷ 8).
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Apply and Analyse 6 (continued)
As at 31 December 20X6, the depreciated carrying amount of the previously revalued
machine was not materially different from its fair value, and the remainder of the class of
assets was not revalued. No changes in estimated useful life or residual value had occurred
since 31 December 20X5. However, there was an indication the machine could be impaired
due to technical improvements in a competitor’s machines, and HRC estimated the
recoverable amount of the equipment (in accordance with HKAS 36 Impairment of Assets:
see Chapter 14) as HK$600,000.
Twelve months later, this threat no longer existed because the technical improvements
proved to be unreliable, and the asset’s recoverable amount was reassessed as
HK$680,000. In addition, because of a domestic currency devaluation, the current market
buying prices of new items of the same equipment increased to HK$1 million, and the
item’s estimated residual value increased to HK$60,000. The item’s estimated useful life
remained unchanged.
Required
Account for the purchase, depreciation, impairment and revaluation of HRC’s specialised
item of lifting equipment for the three financial years ending on 31 December 20X7, by
presenting the accounting entries for those events. In presenting those entries:
• Present only those entries for revaluations for restating separately the asset’s gross
amount and related accumulated depreciation; and
• Exclude the accounting entry for the revaluation of the equipment as of 31
December 20X5, which is presented in the Apply and Analyse in Section 7.4.2.
Analysis
Accounting entries
As at date of purchase (1 January 20X5)
Debit Credit
HK$ HK$
Equipment 850,000
Cash 850,000
(Recognition of purchase of item of equipment)
As at 31 December 20X5
Debit Credit
HK$ HK$
Depreciation expense – equipment 100,000
Accumulated depreciation – equipment 100,000
(Recognition of depreciation for the year, based on the pre-revaluation carrying
amount)
((HK$850,000 − HK$50,000) ÷ 8)
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Apply and Analyse 6 (continued)
As at 31 December 20X6
Debit Credit
HK$ HK$
Depreciation expense – equipment 110,000
Accumulated depreciation – equipment 110,000
(Recognition of depreciation for the year, based on the revalued carrying amount)
((HK$935,000 − HK$55,000) ÷ 8)
Debit Credit
HK$ HK$
Revaluation surplus (other comprehensive income) 75,000
Impairment loss (profit or loss) 40,000
Accumulated impairment loss – equipment 115,000
(Recognition of impairment loss on equipment)
(Calculated as HK$825,000 − HK$110,000 (20X6 depreciation) − HK$600,000
HKAS recoverable amount = HK$115,000. In accordance with HKAS 36 (see Section 7.4.2), the
36.60 impairment loss on a revalued asset is accounted for as a revaluation decrease. Therefore,
the loss is debited to other comprehensive income to the extent of the existing credit
balance in revaluation surplus in respect of the asset (HK$75,000); the remainder of the
decrease is recognised in profit or loss.)
As at 31 December 20X7
Debit Credit
HK$ HK$
Depreciation expense – equipment 90,833
Accumulated depreciation – equipment 90,833
(Recognition of depreciation for the year, based on the asset’s recoverable amount)
((HK$600,000 − HK$55,000) ÷ 6 years remaining useful life on 1 January 20X7. The
remaining life is used when depreciation is based on an asset’s carrying amount net of
accumulated depreciation and accumulated impairment losses.)
Debit Credit
HK$ HK$
Equipment 65,000
Accumulated impairment loss – equipment 115,000
Accumulated depreciation – equipment 41,667
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Apply and Analyse 6 (continued)
Debit Credit
HK$ HK$
Revaluation surplus (other comprehensive income) 98,333
Reversal of impairment loss (profit or loss) 40,000
(Recognition of revaluation of equipment to fair value as at 31 December 20X7
(HK$647,500))
Fair value is calculated as HK$1,000,000 − ((HK$1,000,000 − HK$60,000) ÷ 8 × 3) =
HK$647,500. Carrying amount immediately before revaluation = HK$600,000 − HK$90,833
(i.e. 20X7 depreciation) = HK$509,167. The amount recognised in comprehensive income =
HK$647,500 − HK$509,167, that is, HK$138,333. Of that amount (HK$138,333), HK$40,000
HKAS
36.119 is credited to profit or loss as a reversal of the impairment loss recognised in profit or loss
HKAS as at 31 December 20X6 in accordance with HKAS 36 and HKAS 16 and the remainder
16.39 (HK$98,333) is credited to revaluation surplus through other comprehensive income.
HKAS 36 states that a reversal of an impairment loss of a revalued item of property,
HKAS plant and equipment is treated as a revaluation increase in accordance with HKAS 16 (see
36.119 Section 7.4.2). Therefore, it makes no difference to the accounting entries whether the
revaluation recognised as of 31 December 20X7 is partially composed of a reversal of an
impairment loss. The only thing that matters for the accounting process is whether the
revaluation includes (partly or wholly) a reversal of a previous write-down of the asset
recognised in profit or loss. Specifically, the separate crediting of HK$40,000 to profit or
loss (as a reversal of the previous impairment loss recognised in profit or loss) and the
remainder (HK$98,333) to revaluation surplus through other comprehensive income would
have been the same if, previously (as at 31 December 20X6), the item of equipment had
been written down, partially through profit or loss, because of a revaluation decrease
rather than an impairment loss.
Under the revaluation model, the asset’s upward remeasurement after recognition of
an impairment loss is not limited to the effects of reversing the previous impairment loss.
This contrasts with reversals of impairments of assets measured on the cost model after
initial recognition: For those assets, upon reversal of an impairment loss, the asset’s
increased carrying amount cannot exceed the carrying amount that would have been
HKAS determined (net of depreciation) had no impairment loss been recognised previously (see
36.117 HKAS 36, as discussed in Chapter 14).
Apply and Analyse 7
Premium Services Limited (Premium) holds two items of property, plant and equipment:
freehold land and a building. The cost of the land is HK$40 million, and the cost of the
building is HK$30 million. The building’s residual value is HK$10 million, its useful life is
20 years and the straight-line method of depreciation is applied. The building’s remaining
useful life as at 31 December 20X0 is 10 years. Premium adopts the cost model for its
property, plant and equipment. Premium’s profit for the year ending 31 December 20X0,
under the cost model, is HK$2 million.
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Apply and Analyse 7 (continued)
As of 31 December 20X0, the fair value of the land is HK$60 million. As of 1 January
20X0, the building’s fair value was HK$25 million. The building’s residual value remains
unchanged during 20X0 at HK$10 million. As of 31 December 20X0, the building’s fair value
equals its fair value as of 1 January 20X0 minus depreciation for the year based on that
opening fair value.
Analyse the impact on Premium’s financial statements for the year ending 31
December 20X0 of its decision to adopt the cost model instead of the revaluation model.
Ignore income tax effects. Evaluate the relative usefulness to users of Premium’s financial
statements when the company measures its property, plant and equipment under the cost
model and the revaluation model.
Analysis
Under the cost model, the building’s accumulated depreciation as of 31 December 20X0
would be HK$10 million (i.e. (HK$30 million − HK$10 million) × (10 ÷ 20 years)), and its
carrying amount as for that date would be HK$20 million. The depreciation expense for
the year in respect of the building is HK$1 million (i.e. (HK$30 million − HK$10 million) ÷
20 years). Under the revaluation model, the building’s depreciation expense for the
year would be HK$1,363,636 (i.e. (HK$25 million − HK$10 million) ÷ 11 remaining years).
Therefore, under the revaluation model, the depreciation expense for the year would
be HK$363,636 greater than under the cost model, and the profit for the year would be
HK$363,636 less than its amount under the cost model (i.e. it would be HK$1,636,364).
The building’s fair value as of 31 December 20X0 is HK$23,636,364 (i.e. HK$25 million −
HK$1,363,636 depreciation).
Premium’s financial aggregates for the year ending 31 December 20X0 under the cost
model and revaluation model are summarised in the table below:
Aggregate Cost model Revaluation model
HK$‘000 HK$‘000
Carrying amount of land (end of year) 40,000 60,000
Carrying amount of building (end of year) 20,000 23,636
Carrying amount of property, plant and equipment 60,000 83,636
(end of year)
Depreciation expense 1,000 1,364
Profit for the year 2,000 1,636
Under the revaluation model, the carrying amount of property, plant and equipment is
39% higher than under the cost model. The depreciation expense is 36% higher, and profit
is 18% lower than under the cost model.
Measuring the Premium’s building under the cost model provides users of financial
statements with information about the remaining (unconsumed) portion of the original
investment in that asset. Some users might be interested in whether Premium is
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Apply and Analyse 7 (continued)
generating sufficient income to recover that original investment. However, users are
essentially interested in making predictions about the entity’s future inflows and outflows
of resources based on the information in Premium’s financial statements and other
publicly available information, such as industry data. Many consider that measuring
Premium’s depreciation on a fair value basis provides more relevant information than
historical cost-based depreciation for predicting Premium’s future consumptions of
resources in carrying on its business. Premium’s profitability is significantly lower when the
measurement of its building’s depreciation is based on the building’s fair value, and this
indicates Premium is more vulnerable to a downturn in revenue than a historical
cost-based measure of profit would suggest. In addition, the higher measure of
depreciation expense provides more relevant information about the sustainability of
Premium’s business model because any viable business needs to generate sufficient
income to recover the cost of currently investing in that business.
A considerable period has elapsed since Premium acquired its land and building.
Measuring those assets at fair value would show Premium’s current investment in the
service capacity those assets provide, which is relevant for predicting future cash outflows
on asset replacements. In addition, the fair value of those assets is likely to be more
relevant than their cost for assessing their value for being pledged as security for new
borrowings. Because the carrying amounts of the land and building are in aggregate 39%
higher under the revaluation model than under the cost model provides insights into the
amount of cash Premium could raise from their disposal. However, items of property,
plant and equipment, by their nature, are likely to require replacement if disposed of and,
therefore, their fair values should not be viewed as an indication of free cash flow.
The residual value, useful life and depreciation method for an asset are reviewed at least
every financial year-end if expectations differ from previous estimates of the residual value
or useful life, those estimates are revised accordingly. If a significant change occurs in the
expected pattern of consumption of the future economic benefits embodied in the asset, the
depreciation method is changed to reflect the changed pattern.
A change in residual value, useful life, or depreciation method is accounted for as a change
in an accounting estimate in accordance with HKAS 8 Accounting Policies, Changes in Accounting
Estimates and Errors (see Chapter 16).
A decrease in an asset’s residual value due to a decline in its market value and a decrease in
an asset’s useful life due to obsolescence or physical damage are identified in HKAS 36
HKAS Impairment of Assets as indications that the asset is impaired, requiring estimation of the asset’s
36.9, 12 recoverable amount (see Chapter 14). If the asset is not impaired, the reduction in residual
value or useful life is reflected in revised depreciation charges over the asset’s remaining useful
life. If the asset is impaired, the impairment loss is recognised immediately, typically in
profit or loss.
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Knowledge Check Questions
Question 4
Identify which one of the following statements is not true.
A Because, under the cost model, assets are carried at amounts based primarily on prices
in actual purchase transactions, the economic significance of asset totals is easy to
understand under that model.
B The cost model tends to be less expensive to apply than the revaluation model because
it does not involve obtaining regular valuations of assets.
C Some argue that measuring costs and operating margins using current prices under
the revaluation model provides more useful information for predicting future costs and
operating margins than measuring those metrics using historical costs.
D Measurements under the cost model and revaluation model are subject to estimation
uncertainty.
Question 5
Identify which one of the following statements is true under HKAS 16.
A If an entity revalues an item of property, plant and equipment, it must revalue all its
property, plant and equipment.
B When an item of property, plant and equipment is revalued, the treatment of the
existing balance of accumulated depreciation (i.e. whether it is eliminated against the
asset’s gross carrying amount or restated consistently with the change in the asset’s
carrying amount) does not affect the amount of the revaluation increase or decrease
recognised within comprehensive income.
C A revaluation surplus recognised in respect of an item of property, plant and equipment
may be transferred to retained earnings through other comprehensive income but only
on disposal of that item.
D The residual value of an item of property, plant and equipment is the estimated amount
that the entity will obtain from disposal of the asset at the end of its useful life.
Question 6
Demonstrate the effect on the statement of financial position and statement of profit or
loss and other comprehensive income of HRC deciding to extend the estimated useful life
of one of its cranes from eight years to 12 years.
7 . 5 DERECOGNITION
The carrying amount of an item (or component) of property, plant and equipment is
derecognised when the criteria for recognition (see Section 7.2) are no longer met. That occurs
HKAS
when that item is disposed of, or no future economic benefits are expected from the asset’s
16.67 use or disposal.
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HKAS An asset might be disposed of in various ways, for example, by sale, entry into a finance
16.69 lease, or donation. Disposal occurs when the recipient obtains control of the asset. Some sales
transactions do not result in derecognition of the asset sold because the recipient never gains
control of that asset. In accordance with HKFRS 15 Revenue from Contracts with Customers, if the
HKFRS vendor has a right or an obligation to repurchase the asset sold, the recipient does not obtain
15.B66 control of the asset (see Chapter 5).
The gain or loss arising from derecognising an item of property, plant and equipment
is included in profit or loss when the item is derecognised unless HKFRS 16 Leases requires
otherwise on a sale and leaseback (see Chapter 9). That gain or loss is measured as follows:
Gain or loss on derecognition net proceeds on disposal dere
ecognised item´s carrying amount
The derecognised item’s carrying amount accounts for depreciation for the current period
until the derecognition date.
The proceeds of disposal are measured as the amount of consideration to which an entity
expects to be entitled in exchange for transferring the promised goods, excluding amounts
HKAS collected on behalf of third parties (the requirements for determining the transaction price in
16.68, 71, 72 HKFRS 15 set out in Chapter 5 establish how to determine this amount).
Gains upon derecognition of property, plant and equipment are not classified as revenue.
However, an entity might, in its ordinary activities, hold items of property, plant and
equipment for rental to others and then cease renting them, following which it would sell
those items. When those items cease being rented and become held for sale, they are
transferred from property, plant and equipment to inventories at their carrying amount (see
HKAS
Section 7.5.1). The proceeds from selling those assets are recognised as revenue in accordance
16.68–68A with HKFRS 15.
Key Learning Point
Gains on the derecognition of an item of property, plant or equipment are not recognised
as revenue.
The gain or loss upon derecognition of a revalued asset is measured by reference to that
asset’s revalued carrying amount. Therefore, the entity does not reverse an existing balance
of revaluation surplus in respect to that asset and recognise the amount of gain or loss that
would have arisen if the asset had been measured under the cost model. As is mentioned
in Section 7.4.2, when a revalued asset is derecognised, the balance of revaluation surplus
included in equity in respect of that asset may be transferred to retained earnings. However,
such a transfer is made directly to retained earnings (i.e. not recycled through profit or loss).
Consequently, for a revalued asset, the amount of income recognised in profit or loss over
the asset’s life is reduced to the extent of the existing revaluation surplus when the asset is
derecognised.
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Apply and Analyse 8
Tseung Quang Limited (Tseung Quang) acquired an item of plant on 1 July 20X5 for
HK$800,000, which it measures on the revaluation basis. The plant’s fair value on
31 December 20X8 was HK$325,000 (comprising a gross carrying amount of HK$900,000
and accumulated depreciation of HK$575,000), and the balance of revaluation surplus in
respect of that item of plant was HK$70,000.
The company sold the item of plant on 7 January 20X9 for HK$300,000. On that date,
the buyer obtained control of the sold item of plant. Costs to sell the item were immaterial.
The company sold the item for a lower price than its fair value estimate because it wanted
a quick sale for improved liquidity.
Upon disposing of the item of plant, the company elected to transfer to retained
earnings the balance of revaluation surplus included in equity with respect to that asset
(which was HK$70,000).
Analyse the information provided to determine how Tseung Quang should account for
the sale of the item of plant on 7 January 20X9 and the related voluntary transfer of the
balance of revaluation surplus, in accordance with HKAS 16. Present the accounting entries
that reflect the required treatment.
Analysis
The carrying amount of the item of plant was derecognised on disposal, which was
determined as occurring when the buyer obtained control of that item. This occurred
on 7 January 20X9. The resulting loss recognised in profit or loss was determined as the
difference between the net sale proceeds (HK$300,000) and the item’s carrying amount
(HK$325,000). The balance of revaluation surplus with respect to that item of plant
(HK$70,000) had no effect on the calculation of the loss on sale or the requirement to
recognise that loss in profit or loss.
The accounting entry to reflect the sale on 7 January 20X9 is:
Debit Credit
HK$ HK$
Cash 300,000
Accumulated depreciation 575,000
Loss on sale 25,000
Plant 900,000
The accounting entry to recognise the transfer to retained earnings of the
existing balance of revaluation surplus in relation to the item of disposed plant (as at
7 January 20X9) is:
Debit Credit
HK$ HK$
Revaluation surplus 70,000
Retained earnings 70,000
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7.5.1 Transfer of Assets from or to Property, Plant and Equipment
Items of property, plant and equipment may be removed from that category of assets without
being derecognised. This occurs when those items are reclassified to another category of assets
(e.g. assets held for sale or investment properties). Conversely, investment properties might be
reclassified as items of property, plant and equipment.
The accounting requirements for transfers between property, plant and equipment and
investment property are set out in HKAS 40 Investment Property (see Chapter 8). The accounting
requirement for transfers from property, plant and equipment to non-current assets ‘held for
sale’ are set out in HKFRS 5 Non-current Assets Held for Sale and Discontinued Operations (see
Chapter 15).
Knowledge Check Question
Question 7
Consider one of HRC’s transport trucks. Assume the following:
• The truck was purchased on 1 January 20X5.
• HRC recognised depreciation using the straight-line method up to 31 December
20X6.
• The truck’s acquisition cost was HK$1.1 million.
• The truck’s estimated residual value is HK$100,000.
• The truck’s estimated useful life is five years; consequently, the balance of
accumulated depreciation for the truck as at 31 December 20X6 is HK$400,000.
Assume also that the truck was involved in an accident on 31 March 20X7 and was
burnt beyond repair or salvage (i.e. it became worthless). HRC expects to receive insurance
proceeds of HK$625,000 (the truck’s market value) for the loss of the truck. However, on
31 March 20X7, the compensation was not yet receivable because HRC had not lodged an
insurance claim and, the insurer accepted liability for a claim only once it established the
driver was not negligent.
Identify which one of the following statements is true regarding the use of HRC’s truck
during the financial year beginning 1 January 20X7, the loss of the truck and third-party
compensation for that loss.
A Depreciation is not recognised with respect to the truck for the three months until
31 March 20X7 because the truck is written off during the same financial year.
B The insurance compensation income is recognised as at 31 March 20X7 because that
compensation resulted from the loss of the truck occurring on that date.
C Because the insurance compensation was not receivable as at 31 March 20X7:
• neither a right to compensation nor the related income should be recognised as at
31 March 20X7; and
• derecognition of the truck (and recognition of a corresponding loss) should be
deferred until the insurance compensation becomes receivable.
D The truck should be derecognised as at 31 March 20X7; however, neither a right to
compensation nor the related income should be recognised as at 31 March 20X7.
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7 . 6 DISCLOSURE
Property, plant and equipment often form a significant part of an entity’s assets, and their
depreciation often is a significant expense. Therefore, information about an entity’s property,
plant and equipment is often important to users of financial statements in making resource
allocation decisions about an entity. HKAS 16 specifies, for each class of property, plant and
equipment, disclosures about their amount and the accounting judgements applied to them
(including the choice of measurement basis and assumptions made about uncertain future
events, e.g. their useful lives).
An entity discloses the following for each class of property, plant and equipment:
• A reconciliation of the carrying amount at the beginning and end of the period
(see Section 7.6);
• The measurement basis (cost model or revaluation model);
• The depreciation methods used;
• The useful lives or the depreciation rates used;
• Depreciation for the period;
• Accumulated depreciation; and
HKAS • The gross carrying amount and the accumulated depreciation (aggregated with
16.73, 75 accumulated impairment losses) at the beginning and end of the period.
An entity also discloses the following information about property, plant and equipment:
• Any restrictions on an asset’s title, and assets pledged as security for liabilities;
• The amount of expenditures recognised in the carrying amount of an asset in the
course of its construction;
HKAS
16.74 & 74A • The amount of contractual commitments for the acquisition of assets.
In addition, if not presented separately in the statement of comprehensive income an entity
shall disclose:
• The amount of compensation from third parties recognised in profit or loss for assets
that were impaired, lost or given up; and
• The amounts of proceeds and costs included in profit or loss on items produced
while bringing an item of property, plant and equipment to the condition and location
necessary for it to be capable of operating in the intended manner (per paragraph
20A of HKAS 16), and which line item(s) in the statement of comprehensive income
include(s) such proceeds and costs (HKAS 16.74A).
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The following disclosures are made about items of property, plant and equipment stated at
revalued amounts:
• The effective date of the revaluation;
• Whether an independent valuer was involved;
• For each revalued class of assets, the carrying amount that would have been recognised
had the assets been carried under the cost model;
HKAS • The revaluation surplus showing the change for the period and any restrictions on the
16.77 distribution of the balance to shareholders; and
• The information required by HKFRS 13, for example, the valuation techniques and
HKAS inputs used to develop the fair value measurements, including the level of the fair value
16.77 hierarchy within which the fair value measurements are categorised in their entirety
(see Chapter 4).
HKAS 16 also encourages disclosure of the following information about property, plant and
equipment that users of financial statements might find relevant:
• The carrying amount of temporarily idle assets;
• The gross carrying amount of any fully depreciated assets still in use;
• The carrying amount of any assets retired from active use and not classified as held
for sale; and
HKAS • When the cost model is used, the fair value of assets when it is materially different from
16.79 their carrying amount.
Disclosures about property, plant and equipment are not limited to those set out in
HKAS 16. For example, an entity must also disclose information about:
• Impairment losses (or reversals thereof) in relation to property, plant and equipment,
specified by HKAS 36 Impairment of Assets (see Chapter 14);
• Changes in accounting estimates (e.g. changes in useful lives), specified by HKAS 8
Accounting Policies, Changes in Accounting Estimates and Errors (see Chapter 16);
• Assumptions and other major sources of estimation uncertainty with a significant risk
of subsequent adjustments, specified by HKAS 1 Presentation of Financial Statements
(see Chapter 27); and
• The change in revaluation surplus arising from a change in a liability for dismantling
and removing an item of property, plant and equipment measured using the
revaluation model and restoring the site on which that item is located, specified by
HK (IFRIC) HK (IFRIC) Interpretation 1 (HK(IFRIC) Int-1) Changes in Existing Decommissioning,
1.6(d) Restoration and Similar Liabilities.
Exhibit 7.5 is an extract from the note to the financial statements of HRC disclosing the
depreciation method used and range of useful lives for each class of property, plant and
equipment.
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Land and buildings, and cranes and other lifting equipment are measured subsequent to
recognition under the revaluation model and, therefore, are measured at fair value at the
date of the revaluation (see Note X) less any subsequent accumulated depreciation and
subsequent accumulated impairment losses. Trucks, furniture and fittings are measured
subsequent to recognition under the cost model and, therefore, are measured at cost less
any accumulated depreciation and accumulated impairment losses.
All items of property, plant and equipment other than freehold land are depreciated over
their useful lives. Trucks are depreciated using the diminishing balance method. All other
classes are depreciated using the straight-line method. The estimated useful lives for each
class (excluding the freehold land component of land and buildings) are set out below:
Buildings 30 – 40 years
Cranes and other lifting equipment:
Hoists, controls, motors and hydraulic systems 8 – 10 years
Booms 15 – 20 years
Carry deck 20 – 25 years
Trucks 12 – 15 years
Furniture and fittings 15 – 20 years
EXHIBIT 7.5 Note regarding measurement basis and depreciation (HRC)
Exhibit 7.6 is an extract from the note in HRC’s financial statements presenting its
reconciliation of the carrying amount of some of its classes of property, plant and equipment at
the beginning and end of the financial year. The amounts shown do not incorporate the other
illustrations of HRC’s property, plant and equipment in this Chapter. In addition, comparative
information is not presented.
This illustration of a reconciliation of the carrying amount of property, plant and equipment
at the beginning and end of the financial year looks like a typical reconciliation for an entity.
However, in some circumstances, some of the following reconciliation items arise, in which
instances HKAS 16 requires them to be included in the reconciliation:
• Acquisitions through business combinations;
• Disposals other than transfers of assets to the ‘held for sale’ category;
• Changes resulting from the recognition or reversal of impairment losses through other
comprehensive income; and
• Net exchange differences arising on translation of the financial statements from the
HKAS functional currency into a different presentation currency (including translation of a
16.73, 75 foreign operation).
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All amounts are in HK$ hundreds of thousands. The accumulated depreciation column also
includes the amount of any accumulated impairment losses.
Land and buildings Cranes and other Trucks Total
lifting equipment
Gross Acc. Net Gross Acc. Net Gross Acc. Net
Dep’n Dep’n Dep’n
At 1 January 20X0 610 60 550 420 55 365 195 43 152 1,067
Additions – – – 45 – 45 15 – 15 60
Transfer to – – – (40) (22) (18) – – – (18)
held for sale
Revaluations 31 3 28 13 2 11 – – – 39
Impairment losses – – – – – – – 30 (30) (30)
recognised in
profit or loss
Impairment – – – – (17) 17 – – – 17
losses reversed in
profit or loss
Depreciation – 11 (11) – 28 (28) – 14 (14) (53)
Transfer to (220) (22) (198) – – – – – – (198)
investment property
At 31 December 20X0 421 52 369 438 46 392 210 87 123 884
EXHIBIT 7.6 Reconciliation of the carrying amount of property, plant and equipment at the
beginning and end of the financial year (HRC)
Apply and Analyse 9
HRC measured its land and buildings on the revaluation model and measured its furniture
and fittings on the cost model. As of 1 January 20X8, the carrying amount of HRC’s land
and buildings was HK$51 million (gross carrying amount HK$71 million – accumulated
depreciation HK$20 million) and of its furniture and fittings was HK$14 million (gross
carrying amount HK$37 million – accumulated depreciation HK$23 million).On 30 June
20X8, HRC recognised the following amounts in relation to those classes of assets as a
result of a business combination:
• land and buildings: HK$68 million; and
• furniture and fittings: HK$20 million.
On 1 October 20X8, HRC sold office furniture with a carrying amount of HK$3 million
(gross carrying amount HK$5 million – accumulated depreciation HK$2 million).
The depreciation expense for the year ending 31 December 20X8 was HK$2 million for
HRC’s buildings and HK$3 million for HRC’s furniture and fittings.
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Apply and Analyse 9 (continued)
The following impairment losses were recognised as at 31 December 20X8:
• land and buildings: HK$4 million (recognised in other comprehensive income); and
• furniture and fittings: HK$2 million (recognised in profit or loss).
HRC’s land and buildings were not revalued as of 31 December 20X8 because the most
recently determined revalued carrying amount less subsequent accumulated depreciation
and subsequent impairment losses was assessed as not differing materially from fair value
as of 31 December 20X8.
Required
Prepare the reconciliation of the carrying amount of HRC’s land, buildings, furniture and
fittings at the beginning and end of the financial year ending 31 December 20X8 for the
purpose of the note disclosures in HRC’s annual financial statements.
Analysis
Each event in the fact pattern requires disclosure in the reconciliation. HKAS 16 requires
separate disclosure of the impairment losses recognised in profit or loss and in other
comprehensive income.
In the following reconciliation, all amounts are in HK$ hundreds of thousands, and the
accumulated depreciation column includes the amount of any accumulated impairment
losses.
Land and buildings Furniture and fittings Total
Gross Acc. Net Gross Acc. Net
Dep’n Dep’n
At 1 January 20X0 710 200 510 370 230 140 650
Acquisitions through 680 – 680 200 – 200 880
business combination
Disposal other than – – – (50) (20) (30) (30)
a transfer to held for
sale category
Depreciation – 20 (20) – 30 (30) (50)
Impairment loss recognised – – – – 20 (20) (20)
in profit or loss
Impairment loss – 40 (40) – – – (40)
recognised in other
comprehensive income
At 31 December 20X0 1,390 260 1,130 520 260 260 1,390
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Apply and Analyse 10
HRC proposes to make the following disclosures in the notes to its financial statements:
Land, buildings, cranes and other lifting equipment are measured subsequent to
recognition under the revaluation model and, therefore, are measured at fair value at the
date of the revaluation (see Note X) less any subsequent accumulated depreciation and
subsequent accumulated impairment losses. Trucks, furniture and fittings are measured
subsequent to recognition under the cost model and, therefore, are measured at cost less
any accumulated depreciation and accumulated impairment losses.
All items of property, plant and equipment other than freehold land are depreciated
over their useful lives. Their useful lives range from three to 50 years. They are depreciated
using the straight-line method or diminishing balance method as selected by management
taking into account all facts and circumstances.
Appraise the proposed disclosures.
Analysis
The proposed disclosure of the measurement bases used to determine the gross carrying
amount satisfies the requirement in HKAS 16 to disclose that information for each class of
property, plant and equipment. However:
• The proposed disclosure of the depreciation methods does not satisfy the
requirement in HKAS 16 to disclose that information for each class of property,
plant and equipment; and
• The proposed disclosure of the useful lives does not satisfy the requirement
in HKAS 16 to disclose that information for each class of property, plant and
equipment. Because of that omission and the broad range of useful lives that
would be disclosed, the proposed disclosure would not be useful to users of HRC’s
financial statements in:
°° Assessing the reasonableness of management’s estimates of useful lives;
°° Developing estimates of the likely timing of future outflows on asset
replacements; or
°° Assessing the extent to which the entity’s business model is vulnerable to
technological and other changes where the entity’s assets have long, useful lives.
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Knowledge Check Question
Question 8
Identify which one of the following statements is not true regarding the disclosure
requirements in HKAS 16.
A For items of property, plant and equipment stated at revalued amounts, disclosure is
required of the effective date of the revaluation
B For items of property, plant and equipment stated at revalued amounts, disclosure is
required of whether an independent valuer was involved
C Regardless of whether items of property, plant and equipment are measured under the
cost model or revaluation model, the entity is required to disclose by note the amount at
which they would have been carried under the other measurement model
D An entity is required to disclose the amount of compensation from third parties
recognised in profit or loss for assets that were impaired, lost or given up
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SUMMARY
• HKAS 16 specifies the accounting for property, plant and equipment that is outside the scope
of another HKFRS (e.g. it does not apply to assets held for sale).
• Property, plant and equipment are tangible items:
° held for use in the production or supply of goods or services, for rental to others, or for
administrative purposes; and
° expected to be used during more than one period.
• The cost of an item of property, plant and equipment is recognised as an asset if:
° it is probable that the item will generate future economic benefits; and
° the item’s cost can be measured reliably.
• When an item of property, plant and equipment is initially recognised, it is measured
at its cost.
• The cost of an asset includes its purchase price, costs directly attributable to making the asset
ready for its intended use and the costs of extinguishing obligations to remove the asset and
restore the site on which it is located.
• An asset’s cost is measured as the cash or cash equivalents paid to acquire it plus the
fair value of any non-cash consideration paid as at the time of the asset’s acquisition or
construction.
• Subsequent to its initial recognition, an asset may be measured using either the cost model or
revaluation model:
°° Under the cost model, an asset is measured at its original cost less any accumulated
depreciation and accumulated impairment losses; and
°° Under the revaluation model, an asset is measured at its fair value at the date of
revaluation less any subsequent accumulated depreciation and accumulated impairment
losses with all assets in the same class of assets revalued and revaluations updated
sufficiently regularly to avoid material misstatement of the assets’ fair values.
• Revaluation increases are credited to revaluation surplus through other comprehensive
income, and revaluation decreases are recognised as losses in profit or loss.
°° However, to the extent that a revaluation in effect reverses a previous revaluation
of the same asset, the adjustment to equity is made through the same section of
comprehensive income (i.e. profit or loss; or other comprehensive income) as the
previous revaluation entry.
• An item of property, plant and equipment is depreciated over its useful life by systematically
allocating its depreciable amount over that period.
°° An asset’s depreciable amount is its cost (or other amount substituted for cost) less its
residual value.
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• Depreciation commences when the asset is ready for its intended use and ceases at the
earlier of when the asset is held for sale or derecognised.
• Depreciation charges are recognised as expenses of the current period unless they are
included in the cost of another asset produced by using the asset being depreciated.
• An entity reviews the residual value, useful life and depreciation method (pattern of
consumption) at least every financial year-end for changes, and it accounts for any changes
prospectively (i.e. over the asset’s remaining useful life).
• The carrying amount of an asset is derecognised when the asset is disposed of or no future
economic benefits are expected from the asset’s use or disposal.
°° The resulting gain or loss is recognised in profit or loss when the asset is derecognised
unless HKFRS 16 Leases requires otherwise on a sale and leaseback.
• An entity discloses sufficient information to enable users of its financial statements to assess,
for each class of property, plant and equipment:
° its amount and changes in that amount during the period (including their nature, for
example, revaluations);
° the extent to which the costs of assets have been consumed through use or impairment;
° the judgements made affecting estimates of depreciation (e.g. useful lives); and
° the existence and amount of restrictions over assets.
• An entity discloses information about any revalued property, plant and equipment, including:
° the effective date of the revaluation and whether an independent valuer was
involved; and
° information required by HKFRS 13 Fair Value Measurement, for example, the valuation
techniques and inputs used in fair value measurements.
• An entity also discloses any changes in accounting estimates regarding assets if those changes
have an effect in the current period or are expected to have an effect in subsequent periods.
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MIND MAP
OVERVIEW AND SCOPE DERECOGNITION
All property, plant and equipment outside Derecognise asset’s carrying amount when
the scope of another HKFRS either
Scope includes • Assets disposed of
• Assets held for sale • No future benefits expected from asset
• Right-of-use assets under leases Gain/loss on derecongnition recognised in
• Biological assets and measurement of profit or loss unless HKFRS 16 requires
exploration and evaluation assets otherwise on a sale a leaseback
• Mineral rights and non-regenerative
resources such as mineral reserves RECOGNITION
PROPERTY, PLANT Recognition criteria for an asset
MEASUREMENT AT RECOGNITION
AND EQUIPMENT • Probable future benefits
Cost HKAS 16 • Cost o reliably measurable
• Cash and cash equivalents paid Apply recognition cetera to initial and
• Fair value of non-cash consideration subsequent costs
After initial recognition, choose Examples of subsequent costs
measurement model to recognise • Replacements of asset components
depreciation and any impairment losses • Enhancements of assets
• Costs of day-to-day servicing (write-off
MEASUREMENT AFTER RECOGNITION to expense)
For each class of assets, apply either cost
model or revaluation model DISCLOSURE
Cost model For each class of assets, disclose
• Carry asset at cost less: information about
- Accumulated depreciation • The amount and changes in amount
- Accumulated impairment losses under • Depreciation estimates
HKAS 36 • Restrictions
Revaluation model Disclose information about any revalued
• Carry asset at fair value at the date of assets, including that required by HKFRS 13
revaluation less any subsequent: Disclose changes in accounting estimates
- Accumulated depreciation
- Accumulated impairment losses under
HKAS 36
• Update revaluations to maintain fair value
• Treatment of revaluation:
- Increases –CR other comprehensive income
- Decreases– DR expense
- Except where a reversal of a revaluation
of the same asset
Answers to Knowledge Check Questions
Question 1
A The baling device should be recognised as an asset as at 30 April 20X9 because it is
probable to provide future economic benefits and its cost can be measured reliably.
It should be measured initially at its cost of HK$2.5 million. The existing baling device
should be derecognised because it was removed (as having no remaining future
economic benefits) on 30 April 20X9.
Accounting entries as at 30 April 20X9
Debit Credit
HK$’000 HK$’000
Loss on derecognition of plant and equipment (baling device) 350
Plant and equipment (baling device) 350
(Derecognition of baling device upon its removal and replacement)
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Debit Credit
HK$’000 HK$’000
Plant and equipment (baling device) 2,500
Cash 2,500
(Initial recognition of replacement baling device, at cost)
B The anti-pollution filter is necessary for continuing to operate the facility and, therefore,
necessary for the entity to obtain the future economic benefits from those other
components of the manufacturing facility. Accordingly, the anti-pollution filter satisfies the
recognition criterion of being probable to provide future economic benefits. In addition,
its cost can be measured reliably. Therefore, the filter should be recognised, as of 1 June
20X9, as a separate component of the manufacturing facility because its useful life differs
from other components of the facility. The anti-pollution filter should initially be measured
at its cost of HK$2 million, and no components of the facility warrant derecognition as a
result of installing the filter.
Accounting entry as at 1 June 20X9
Debit Credit
HK$’000 HK$’000
Plant and equipment (anti-pollution filter) 2,000
Cash 2,000
(Initial recognition of new anti-pollution filter, at cost)
C Because the new sorting device (with a purchase price of HK$800,000) was ineffective
in enhancing the production process and was scrapped, it failed the probable future
economic benefits criterion for recognition as an item of property, plant and equipment.
Therefore, the cost of acquisition of that item (HK$830,000, composed of its purchase
price of HK$800,000 and its installation cost of HK$30,000) should be recognised
immediately as an expense. The carrying amount of the sorting device that was replaced
and then reinstalled (HK$200,000) should not be derecognised, because the entity did
not dispose of that asset and future economic benefits are expected from its use. That
amount (HK$200,000) should be depreciated over the remainder of the sorting device’s
useful life. The cost of reinstalling that sorting device does not satisfy the probable future
economic benefit criterion for recognition as an item of property, plant and equipment
because it does not increase the device’s useful life or either the quality or quantity of
outputs the device is expected to produce. That cost (HK$25,000) should be recognised
as an expense when incurred (i.e. as at 30 September 20X9), as part of the ‘equipment
failure expense’ calculated as HK$830,000 + HK$25,000 = HK$855,000.
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Accounting entry as at 30 September 20X9
Debit Credit
HK$’000 HK$’000
Equipment failure expense 855
Cash 855
(Immediate write-off of costs associated with the unsuccessful purchase and installation of new
equipment and the reinstallation of old equipment)
D The cost of the mandatory major safety inspection of the facility performed on 15
December 20X9 (HK$150,000) should be capitalised (and subsequently depreciated)
in accordance with HKAS 16. Because the previous major inspection component had
been fully depreciated, no amount should be derecognised when the current period’s
inspection cost is capitalised.
Accounting entry as at 15 December 20X9
Debit Credit
HK$’000 HK$’000
Plant and equipment (major inspection component) 150
Cash 150
(Initial recognition of major safety inspection component of the facility, at cost)
Question 2
Answer A is correct. The cost of an item of property, plant and equipment is measured
at the item’s cash price equivalent regardless of when payment for the item occurs.
Therefore, the statement in A is not true. If payment for an item is deferred beyond normal
credit terms, both of the following occur:
1. The item’s cost is measured at its cash price equivalent; and
2. The difference between the cash price equivalent and the total payment is
recognised as interest over the period of credit unless such interest is capitalised in
accordance with HKAS 23 Borrowing Costs.
Answer B is incorrect. In principle, the cost of an item of property, plant and equipment
acquired through an exchange of non-monetary assets is measured at its fair value at
its date of recognition. In practice, HKAS 16 also specifies criteria for using fair value to
measure the item’s cost.
Answer C is incorrect. The cost of an item of property, plant and equipment acquired
through an exchange of non-monetary assets is measured at its fair value at its date of
recognition unless:
• The exchange transaction lacks commercial substance; or
• The fair value of neither the asset received nor the asset given up is reliably measurable.
Answer D is incorrect. Where an item of property, plant and equipment acquired through
an exchange of non-monetary assets fails either of the criteria in HKAS 16 for measuring
its cost at its fair value, its cost is measured at the carrying amount of the asset given up
in exchange.
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Question 3
Answer A is incorrect. One of two criteria in HKAS 16 for determining the fair value of an
asset is reliably measurable (meeting either criterion is sufficient) is that the variability in
the range of reasonable fair value measurements is insignificant for that asset. Therefore,
the statement in A is true.
Answer B is incorrect. One of two criteria in HKAS 16 for determining the fair value of an
asset is reliably measurable is that the probabilities of the various estimates within the
range of reasonable fair value measurements for that asset can be reasonably assessed
and used when measuring fair value. Therefore, the statement in B is true.
Answer C is correct. To measure the cost of an item of property, plant and equipment
acquired through an exchange of non-monetary assets at its fair value at its date of
recognition if the fair value of the asset received or given up can be measured reliably, the
fair value of the asset given up – rather than the fair value of the asset received – is used to
measure the cost of the asset received, unless the fair value of the asset received is more
clearly evident. Therefore, the statement in C is not true.
Answer D is incorrect. The purpose of requiring fair value estimates to satisfy a reliable
measurement criterion when measuring the cost of an item of property, plant and
equipment acquired through an exchange of non-monetary assets is to prevent entities
from ‘manufacturing’ gains by attributing inflated values to the assets exchanged. For
example, an asset with a carrying amount of HK$5,000 and no observable market price in
an active market could be exchanged with an asset of similar utility. If the fair value of the
asset exchanged was determined to be HK$7,500 and the measurements were unreliable,
the entity would effectively recognise a ‘manufactured’ gain of HK$2,500 on the exchange.
Therefore, the statement in D is true.
Question 4
Answer A is correct. It is not true to say the economic significance of asset totals is easy to
understand under the cost model because different assets are acquired at different times
when different price levels apply. For example, it is difficult to understand the significance
of the sum of the cost of an asset acquired during the current period and the cost of an
asset acquired 50 years earlier.
Answer B is incorrect. The cost model tends to be less expensive to apply than the
revaluation model because it does not involve obtaining regular valuations of assets.
Answer C is incorrect. Some argue applying the revaluation model provides more
useful information for predicting future costs and operating margins than applying
the cost model because current prices are better predictors of future prices than are
previous prices.
Answer D is incorrect. Measurements under the cost model are subject to estimation
uncertainty because judgements about uncertain future events are necessary when
calculating depreciation and estimating an asset’s recoverable amount.
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Also true is that measurements under the revaluation model are subject to estimation
uncertainty because the fair value of some assets might not be directly observable and
may require estimates that are based on the following:
• Limited market data due to (e.g.) the assets being specialised and/or traded in
markets with a wide dispersion of prices; or
• Estimates of future cash inflows the asset will generate.
Question 5
Answer A is incorrect. HKAS 16 requires that, if an item of item of property, plant and
equipment is revalued, the entire class of assets to which it belongs must be revalued.
However, HKAS 16 does not require other classes of property, plant and equipment to also
be revalued. Therefore, the statement in A is not true.
Answer B is correct. The amount of the revaluation increase or decrease recognised within
comprehensive income is the amount by which the revaluation changes the carrying
amount of the item of property, plant and equipment. The item’s carrying amount, before
and after recognising a revaluation, is net of accumulated depreciation (and accumulated
impairment losses). Therefore, the amount of the revaluation increase or decrease
recognised within comprehensive income is unaffected by whether the existing balance
of accumulated depreciation is eliminated against the asset’s gross carrying amount
or restated consistently with the change in the asset’s carrying amount. Therefore, the
statement in B is true.
Answer C is incorrect. It is not true to say that a revaluation surplus recognised in respect
of an item of property, plant and equipment may only be transferred to retained earnings
on disposal of that item. The balance of that revaluation surplus may also be transferred
as the asset is used by the entity in the amount of each period’s difference between
depreciation based on the asset’s revalued carrying amount and depreciation based on the
asset’s original cost. That balance may also be left in revaluation surplus after the asset is
disposed of.
Answer D is incorrect. The definition of ‘residual value’ in HKAS 16 refers to the estimated
HKAS net amount that the entity would currently obtain from disposal of the asset if the asset
16.6 were of the age and in the condition expected at the end of its useful life. Therefore, the
statement in D is not true.
Question 6
HKAS 16 specifies that a change in an asset’s estimated useful life is accounted for as a
change in an accounting estimate in accordance with HKAS 8 Accounting Policies, Changes in
Accounting Estimates and Errors. Therefore, an extension of the useful life of one of HRC’s
HKAS cranes is accounted for prospectively by allocating the crane’s remaining depreciable
16.51 amount over its revised remaining useful life.
Because the change in estimated useful life is made without making a cumulative
catch-up adjustment to account as if the revised useful life had always been applied to
the asset, the decision to extend the estimated useful life of an asset has no immediate
effect on the carrying amount of the crane in HRC’s statement of financial position. Future
statements of financial position during the crane’s remaining useful life will report higher
carrying amounts for the crane compared with what would have been reported in the
absence of extending the crane’s useful life.
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Allocating the crane’s remaining depreciable amount over its revised remaining
useful life (from when the useful life was re-estimated) causes deceleration of recognising
depreciation for the consumption of the crane’s depreciable amount. This deceleration
means each remaining period’s depreciation charge will be reduced. In aggregate, the
same amount of depreciation expense will be recognised, and the effect of depreciation
on retained earnings by the end of the 12-year useful life will be the same as it would have
been if the crane’s useful life remained unchanged at eight years.
Consequently, the net effect on pre-tax profit or loss will reverse over the crane’s
remaining useful life as follows:
• For the remainder of the crane’s original eight-year useful life, pre-tax profit will be
increased because the recognition of depreciation decelerates; and
• For the additional four years of the crane’s useful life, depreciation charges will be
recognised where once there would have been none in respect of the crane, and pre-
tax profit will be reduced by that amount.
These effects on pre-tax profit will give rise to commensurate changes in each year’s
aggregate (current and deferred) income tax expense, that is, in accordance with HKAS 12
Income Taxes (paras. 46, 47 and 58), the expense will increase for the remainder of the
crane’s original eight-year useful life and reduce for the next four years.
Another effect of extending the crane’s useful life is that, under HKAS 12.15-17, if the
rate of depreciation tax deductions on the crane is not reduced by the same amount
(e.g. if tax depreciation is based on standardised useful lives determined by the taxation
authorities), taxable temporary differences will change. These will result in recognising in
the statement of financial position an increase in any deferred tax liability or a reduction in
any deferred tax asset relating to the crane. (See Chapter 19 for background information
about applying HKAS 12.)
Question 7
Answer A is incorrect. Depreciation of the truck should be recognised for the three months
until 31 March 20X7, which was the end of the truck’s useful life (when the total loss of
the truck occurred). The truck’s annual depreciation under the straight-line method was
HK$200,000, calculated as (HK$1,100,000 − HK$100,000) ÷5 years. Using the same method,
depreciation for three months = HK$50,000. Depreciation and losses upon disposal
have different implications for assessments of an entity’s financial performance and for
predictions of the entity’s future performance. Therefore, it is useful to users of financial
statements to distinguish them.
Answer B is incorrect. As is previously mentioned, compensation from third parties for
items of property, plant and equipment that were impaired, lost or given up are included
in profit or loss when the compensation becomes receivable. Under the facts given, the
insurance compensation was not receivable as of 31 March 20X7.
Answer C is incorrect. The derecognition event (the truck’s destruction) is unaffected by
the existence and timing of recognition of any third-party compensation for that loss (the
proceeds of the insurance claim). HKAS 16 indicates that losses of items of property, plant
and equipment and related claims for compensation are separate economic events that
need not be recognised simultaneously.
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Answer D is correct. HRC’s truck should be derecognised as of 31 March 20X7 with
recognition of a corresponding loss on disposal. However, neither a right to compensation
nor the related income should be recognised as of 31 March 20X7 because of the
following:
• HKAS 16 requires the carrying amount of an item of property, plant and equipment
to be derecognised when no future economic benefits are expected from its
use or disposal. The truck became worthless on 31 March 20X7 because of the
accident; and
• HKAS 16 specifies that compensation from third parties for items of property, plant
and equipment that were impaired, lost, or given up are included in profit or loss
when the compensation becomes receivable. Under the facts given, the insurance
compensation was not receivable as of 31 March 20X7.
Derecognition of the truck’s carrying amount as of 31 March 20X7 involves recognising
a loss equal to the truck’s carrying amount immediately prior to derecognition, which was
HK$650,000.
Question 8
Answer A is incorrect. HKAS 16 does require disclosure of the effective date of revaluation
in respect of revalued property, plant and equipment. Therefore, the statement in A is true.
Answer B is incorrect. For items of property, plant and equipment stated at revalued
amounts, HKAS 16 does require disclosure of whether an independent valuer was involved.
Therefore, the statement in B is true.
Answer C is correct. It is not true to say disclosure of carrying amounts under the
alternative measurement model is required for all items of property, plant and equipment.
Such disclosure is required by HKAS 16 for each revalued class of property, plant and
equipment (i.e. disclosure of the cost model carrying amount is required). However, such
disclosure is encouraged but not required for classes of property, plant and equipment
measured under the cost model (i.e. note disclosure of fair values is encouraged).
Answer D is incorrect. HKAS 16 does require disclosure of the amount of compensation
from third parties recognised in profit or loss for assets that were impaired, lost or given
up. This disclosure requirement applies regardless of the measurement model adopted for
the affected assets. Therefore, the statement in D is true.
EXAM PRACTICE
QUESTION 1
Hi-Rise Cranes Limited (HRC) exchanges an item of lifting equipment located in Hong Kong
for an item of lifting equipment held by Modular Solutions Limited (Modular Solutions)
and located in mainland China. The lifting capacity of the equipment sacrificed by HRC is
slightly superior to the lifting capacity of the equipment obtained in exchange. However, the
equipment sacrificed had a remaining useful life of nine years, whereas the remaining useful
life of the equipment received is 10 years. A key reason for exchanging the equipment was
that, for both parties to the exchange, it avoided the costs of transporting the equipment
between their present location and the location of a customer.
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Sacrificed crane Acquired crane
HK$m HK$m
HRC’s pre-transfer carrying amount of the 2.8
equipment sacrificed (cost HK$4.5 million less
accumulated depreciation HK$1.7 million)
Fair value of equipment exchanged (reliably 3.5 3.5
measurable)
Present value of expected cash flows from the asset 4.5 4.5
(timing, risk and amount of expected cash flows do
not differ)
‘Entity-specific value’, that is, present value of 12.0 12.1
expected post-tax cash flows from the portion of the
entity’s operations affected by the transaction
Required:
(a) Calculate the cost of the equipment acquired from Modular Solutions Limited in
accordance with HKAS 16 and justify your conclusion.
(b) Assume you are the audit senior on the HRC audit and are asked by the chief
accountant to explain why, in some circumstances, the cost of property, plant and
equipment acquired in exchange for non-monetary assets is not measured at fair value.
Prepare a file note that briefly describes the circumstances in which the cost of such an
item is not measured at fair value and justifies the reasons for that rule in HKAS 16.
QUESTION 2
For the following types of property, plant and equipment:
• Consider the factors affecting (i) their useful life, and (ii) the most appropriate
method of depreciation for them; and
• Advise which factor is likely to be most significant to each of (i) and (ii). Justify your
conclusions by reference to the requirements of HKAS 16. Where, based on the
brief fact patterns provided, there is realistically only one relevant potential factor,
discussing other factors is unnecessary.
Property, plant and equipment
(a) Internal walls and other office fixtures in a leased office with a remaining lease term
of two years. The remaining physical lives of those office fixtures range from 10
to 15 years, and the next office reconfiguration is expected to occur after another
five years;
(b) The operating system (software) of the entity’s main computer when that software is
owned by the entity;
(c) An engine on a ski lift at a snow skiing resort;
(d) The surface of a major road normally expected to last for another three years before
replacement but, which in six months’ time, is expected to carry double the usual number
of heavy vehicles because of planned closure of an alternative heavy vehicle route; and
(e) The surface of a lightly trafficked mountain-side road that is replaced, on average, every
five years due to washaways.
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QUESTION 3
Assume you are the senior auditor on the audit of Hi-Rise Cranes Limited (HRC) and
are asked by the chief accountant, Mr. Lam, to explain why items of property, plant and
equipment measured under the cost model in HKAS 16 might be fully depreciated (i.e. have
a carrying amount of zero) even though HRC continues to use them. Advise Mr. Lam your
reasons for this situation.
Assume for simplicity that the asset’s residual value is zero (i.e. the asset is to be
scrapped with unsaleable materials at the end of its useful life).
Mr. Lam also asked the following questions.
• Why can an asset be fully depreciated and still be in continued use only if the asset
was measured under the cost model?
• What are the disclosure implications of continuing to recognise a fully depreciated
asset? Why would disclosure of information about fully depreciated assets provide
useful information to users of HRC’s financial statements?
Advise him your views, including an appraisal of the usefulness of the disclosures HKAS
16 requires about fully depreciated assets.
QUESTION 4
Lantau Horizons Limited (Lantau Horizons) acquires a factory machine for HK$1.2 million
for cash on 1 January 20X0. The machine has an estimated useful life of six years and its
residual value is zero. Lantau Horizons applies the straight-line method of depreciation to
the machine.
The machine is revalued as at 31 December 20X1 to fair value, which was HK$1 million.
The class of assets to which the machine belongs is revalued every five years (in the absence
of more rapid changes in market prices that necessitate more frequent revaluations). The
asset is not revalued again during its useful life, which ended on 31 December 20X5. The
asset was scrapped on that date and replaced the next working day.
Required:
(a) Apply and describe the requirements of HKAS 16 to summarise the changes in assets
and all movements in profit or loss or other comprehensive income that occur in
aggregate over the asset’s life. Ignore income tax effects.
(b) Assume you are the audit senior on the Lantau Horizons audit, and the company’s chief
accountant, Ms. Yang, asks you about the options that HKAS 16 provides for accounting
for the revaluation surplus from the date of the revaluation up to and including the
date of derecognising the machine. Advise her about those options, contrasting their
treatment and explain at least one reason why each of them might be considered to
provide useful information to users.
(c) Apply and describe the disclosure requirements in HKAS 16 for the revaluation and
revalued carrying amount of the machine.
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ANSWERS TO EXAM PRACTICE
QUESTION 1
(a) The facts supplied indicate that, in relation to the item of equipment acquired from
Modular Solutions in exchange for a non-monetary asset, one of the two criteria in
HKAS 16 for measuring at fair value the cost of that item is met. That is, the fair value
of the asset received or given up is reliably measurable. In fact, both are reliably
measurable.
However, the exchange transaction fails to meet the other criterion for measuring
the cost of that item of equipment at fair value, which is that the exchange transaction
must have commercial substance. The analysis leading to that conclusion is set out
below:
• The configuration (timing, risk and amount) of expected cash flows does not differ
between the assets exchanged. Nevertheless, the exchange transaction would still
have commercial substance if both of the following were true:
° The entity-specific value of the portion of the entity’s operations affected by the
transaction changes as a result of the exchange; and
° The difference in the entity-specific value is significant relative to the fair value
of the equipment exchanged.
• Under the facts supplied:
° The entity-specific value of the portion of the entity’s operations affected by
the transaction increases from HK$12 million to HK$12.1 million as a result of
the exchange.
° However, that difference in the entity-specific value (HK$100,000) is insignificant
relative to the fair value of the equipment exchanged, because it is 2.9% of that
fair value (HK$3.5 million).
Therefore, the exchange of equipment fails the ‘commercial substance’ test in
HKAS 16. In accordance with HKAS 16, the cost of the item of equipment acquired
from Modular Solutions does not qualify to be measured at fair value. Instead, the
cost of that item is measured at the carrying amount of the equipment given up by
HRC in exchange, which was HK$2.8 million.
• HKAS 16 prohibits measuring the cost of property, plant and equipment acquired
in exchange for non-monetary assets at fair value when the exchange lacks
commercial substance. In those circumstances, the cost of the asset acquired is
measured at the carrying amount of the asset given up, and a gain on the exchange
cannot be recognised.
Without a ‘commercial substance’ criterion for measuring the cost of an
acquired asset at its fair value, an exchange of assets that has no discernible
effect on an entity’s resources (i.e. the cash-generating capacity of the assets is
unchanged) could possibly give rise to a change in the carrying amounts of assets
and a corresponding effect on profit or loss (in HRC’s circumstances, a gain would
be recognised).
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HKAS 16 also prohibits measuring the cost of property, plant and equipment
acquired in exchange for non-monetary assets at fair value if the fair value of
neither the asset received nor the asset given up is reliably measurable. Reliable
measurement is a general criterion for the recognition of changes in assets. If a
reliable measurement criterion did not apply to the use of fair value estimates in
accounting for exchanges of non-monetary assets, entities could ‘manufacture’
gains by attributing inflated values to the assets exchanged.
QUESTION 2
For any item of property, plant and equipment, its useful life is determined as its expected
use by the entity, whether expressed in terms of a time period or units of production or
similar units.
(a) Considering the four factors identified in HKAS 16 for determining the useful life
of an asset:
(i) the useful life of the office fixtures is unlikely to vary according to the expected
usage of those assets and, therefore, is an unimportant factor in determining their
useful lives;
(ii) physical wear and tear is less important than commercial obsolescence arising
from a need to reconfigure the office layout, which is expected to occur before
physical replacement of the office fittings is required (i.e. except for other factors,
commercial obsolescence would limit the useful lives of the office fixtures to five
years); and
(iii) the most significant factor is the remaining lease term because it expires before
the office fixtures are expected to become commercially obsolete. Although the
lease might be renewed, a risk exists that it might not be. Due to the immobility of
the office fixtures, they would not be used in the entity’s operations after the entity
vacates the premises.
Applying the requirement in HKAS 16 to use a depreciation method that reflects the
pattern in which the asset’s future economic benefits are expected to be consumed by
the entity, the rate and quality of the services provided by the office fixtures are unlikely
to vary over the remaining two years of their useful lives. Therefore, regarding the
depreciation methods identified in HKAS 16:
• There is no apparent reason why the diminishing balance method should be used;
• Applying the units of production method would be expected to yield the same
outcome as applying the straight-line method; and
• The straight-line method is the most appropriate for meeting the requirement
in HKAS 16.
(b) Software that is owned by the entity and forms an integral part of property, plant and
equipment is not subject to any legal or similar limits on its period of use. Therefore,
the most significant factor in HKAS 16 for determining the useful life of such software
owned by the entity is technical or commercial obsolescence. This is because software
tends to quickly become obsolete due to changes either in related systems or because
competing software makes its outputs commercially unviable.
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Because software is primarily subject to technical or commercial obsolescence,
its capacity to help the entity remain competitive will likely diminish over time (i.e.
the quality of its services is expected to decline more quickly in its earlier periods).
Therefore, an entity is likely to apply the diminishing balance method, which results in a
decreasing depreciation charge over the asset’s useful life.
(c) The related factors identified in HKAS 16 that are most significant to determining the
useful life of an engine on a ski lift at a snow skiing resort are expected physical wear
and tear through expected usage of the asset.
Expected physical wear and tear through expected usage of the asset determines
the useful life of the ski lift engine, and the engine’s usage is seasonal. Therefore, an
entity is likely to apply the units of production method of depreciation to that asset.
Hours of use would be an appropriate measure of the services produced by the engine.
(d) The related factors identified in HKAS 16 most significant to determining the useful life
of the surface of a major road are expected physical wear and tear through expected
usage of the asset, particularly usage by heavy vehicles.
The rate of usage by heavy vehicles is expected to change significantly during the
road surface’s remaining useful life. Therefore, an entity is likely to apply the units of
production method of depreciation to that asset.
(e) Because the surface of a lightly trafficked mountain road is typically replaced due to
washaways, the factor identified in HKAS 16 that is most significant to determining the
useful life of the road surface is expected physical wear and tear.
Because that wear and tear is largely unaffected by the road’s rate of usage, the
future economic benefits embodied in the road surface are consumed principally
through the passage of time (the period of time between washaways). Therefore, the
entity is likely to apply the straight-line method of depreciation to that asset.
QUESTION 3
If an entity is still using a fully depreciated asset, this indicates the asset’s most recently
estimated useful life has expired and, therefore, the asset’s useful life was underestimated.
An example of where this might occur is where an entity’s expected period of use of an asset
was shorter than the asset’s economic life and, after the asset’s last period of planned use,
the entity decided to use the asset for the remainder of its economic life.
When applying the requirement in HKAS 16 to review an asset’s useful life and revise it if
expectations about it change:
• If those changed expectations are identified before the financial statements are
authorised for issue for the planned final period of the asset’s use, the asset’s useful life
would be extended and the carrying amount remaining at the start of that period would
not be fully written off; but
• If those changed expectations are identified after the financial statements are
authorised for issue for the planned final period of the asset’s use, the asset’s
depreciable amount would have been fully written off and, for the reason given in the
next paragraph, this could not be reversed. Because the asset has a residual value
of zero, it would not have been transferred from property, plant and equipment to
assets held for sale (within the scope of HKFRS 5 Non-current Assets Held for Sale and
Discontinued Operations) at the end of the asset’s final period of planned use.
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HKAS 16 requires a change in useful life to be accounted for as a change in an
accounting estimate in accordance with HKAS 8 Accounting Policies, Changes in Accounting
Estimates and Errors. Therefore, an extension of an asset’s useful life is accounted for
prospectively, by allocating the remaining depreciable amount over the revised remaining
useful life, without making a cumulative catch-up adjustment to account as if the longer
useful life had always been known. If an asset’s carrying amount was fully written off in
the period preceding the decision (or other event) that extended its useful life, it would be
impossible to reverse the overestimate of depreciation relating to preceding periods.
In contrast, if the asset were measured under the revaluation model, it would be
remeasured to its fair value during the current period (assuming its fair value is materially
greater than zero), despite having been fully written off in a preceding period because
revaluation is not an allocation of cost. For example, if the asset’s fair value were measured
at current replacement cost as described in HKFRS 13 Fair Value Measurement, the estimated
obsolescence included in the asset’s fair value estimate would be revised to reflect the new
information.
Although the asset is fully depreciated under the cost model, the asset is ineligible
for derecognition under HKAS 16 because the asset neither has been disposed of (by
transferring control of it to another entity) nor is expected to fail to generate future
economic benefits from use or disposal.
Because the asset is not derecognised, the disclosure requirements of HKAS 16 continue
to apply to it. Both the gross carrying amount and related accumulated depreciation
(aggregated with any accumulated impairment losses) of the asset need to be disclosed
within the totals of those amounts for the class of assets to which they belong. In addition,
HKAS 16 encourages separate disclosure of the gross carrying amount of any fully
depreciated property, plant and equipment still in use.
Information about the asset’s gross amount and related accumulated depreciation is
useful because, in aggregate for all assets in the class, it helps users of financial statements
identify the age profile of those assets (in percentage terms) and provides information useful
for predicting future outflows on replacements of assets.
QUESTION 4
(a) In accordance with the definition of ‘depreciable amount’ in HKAS 16 and the general
requirement in HKAS 16 to allocate an asset’s depreciable amount over its useful life,
the historical cost-based depreciation of the machine is HK$200,000 per annum for
the first two years of the machine’s useful life, using the straight line method. At the
revaluation date, the machine’s carrying amount (net of accumulated depreciation)
was HK$800,000. Recognition of the revaluation to fair value increased the machine’s
carrying amount by HK$200,000 as at that date, with a corresponding credit to
revaluation surplus of HK$200,000 recognised in other comprehensive income.
Depreciation expense for the four remaining years of the machine’s useful life
increased by an aggregate amount of HK$200,000 in accordance with the definition of
‘depreciable amount’ in HKAS 16 and the general requirement in HKAS 16 to allocate an
asset’s depreciable amount over its useful life. Thus, the depreciation expense for each
of the last four years was HK$250,000, resulting in an aggregate amount of depreciation
of HK$1.4 million, which is HK$200,000 more than the machine’s acquisition cost.
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Having been fully depreciated, the machine is derecognised as of 31 December
20X6 because no future economic benefits are expected from its use or disposal.
This involves removing the account balance for the machine and related accumulated
depreciation.
Over the machine’s life, the aggregate amounts recognised are a reduction in
cash by HK$1.2 million, depreciation expense (and resulting reduction in retained
earnings) of HK$1.4 million and an increase to revaluation surplus by HK$200,000.
The movements in retained earnings and revaluation surplus are subject to the options
described in (b).
(b) In accordance with HKAS 16, the three options for treating the revaluation surplus of
HK$200,000 up to and including the date of derecognising the machine are:
• Leaving the balance of HK$200,000 in the revaluation surplus. Consequently,
the balance of retained earnings would have been reduced by HK$1.4 million
(the machine’s cost of acquisition plus the revaluation increase of HK$200,000
written off as increased depreciation charges) over the machine’s life, ignoring
the amount of revenues generated by using the machine. This option might be
supported on the basis that recognising the revaluation updated the measure of
future economic benefits to be consumed over the machine’s remaining useful life
and, therefore, it is appropriate for retained earnings to be reduced permanently by
the amount of the revaluation increase. In addition, retained earnings and amounts
recognised in profit or loss have no disparity.
• Transferring some of, or all, the revaluation surplus attributable to the machine
(HK$200,000) directly to retained earnings (i.e. through other comprehensive
income) when the machine is derecognised as of 31 December 20X6. This option
might be supported on the basis that transferring all the revaluation surplus to
retained earnings would mean retained earnings reduce by HK$1.2 million (i.e. the
aggregate amount of historical cost-based depreciation) over the life of the machine
and, therefore, align with the cash cost of the machine to the entity. Some might
also support this option because they think it is inappropriate for amounts to
remain in revaluation surplus for an asset no longer recognised by the entity.
• Transferring up to HK$50,000 per annum for the four years after the revaluation
date from revaluation surplus directly to retained earnings (i.e. through other
comprehensive income), with any amount still remaining when the machine
is derecognised left in revaluation surplus or transferred to retained earnings.
If all the revaluation surplus were transferred to retained earnings over the
remaining four years, the same arguments as in the second option above would
apply. In addition, the reduction in retained earnings recognised in respect of the
machine each year would be HK$200,000 per annum, calculated as HK$250,000
depreciation – HK$50,000 transfer from revaluation surplus (i.e. the same amount
that would be recognised if the asset had not been revalued).
(c) In accordance with HKAS 16, Lantau Horizons would disclose for the class of assets that
includes the following for the machine:
• The measurement basis for determining the gross carrying amount (fair value);
• The gross carrying amount and the accumulated depreciation at the beginning and
end of the period; and
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• The increase in carrying amount as at 31 December 20X1 resulting from the
revaluation, which would include HK$200,000 in respect of the machine, shown in
the reconciliation of the opening and closing balances for the 20X1 financial year.
In accordance with HKAS 16, Lantau Horizons would disclose the following in
respect of the machine:
• The effective date of the revaluation (31 December 20X1);
• Whether an independent valuer was involved;
• For the class of assets that includes the machine, the carrying amount that would
have been recognised under the cost model. For each 31 December year-end, this
would have been:
° 20X1: HK$800,000;
° 20X2: HK$600,000;
° 20X3: HK$400,000;
° 20X4: HK$200,000; and
• The revaluation surplus (HK$200,000), indicating in the 20X1 financial statements
that the revaluation surplus increased by that amount during the year, and any
restrictions on the distribution of that balance to shareholders.
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8
Investment Property
CHAPTER TOPIC LIST
8.1 Overview 8.4.2 Cost Model
8.1.1 Scope 8.4.3 Fair Value Model
8.1.2 Terminology 8.5 Transfers
8.1.3 Classification of Property as 8.5.1 Evidence of Change in Use and
Investment Property, Owner- Accounting Treatments
occupied Property or Inventory
8.6 Disposals
8.2 Recognition
8.7 Disclosures
8.3 Measurement at Recognition 8.7.1 Fair Value Model
8.4 Measurement after Recognition 8.7.2 Cost Model
8.4.1 Accounting Policy
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LEARNING OUTCOMES
PRINCIPAL LO3: EVALUATE AND ADVISE ON APPROPRIATE ACCOUNTING PRINCIPLES TO ACCOUNT
FOR COMPLEX BUSINESS TRANSACTIONS
LO3.06: A
ccount for, evaluate and advise on business transactions in accordance with Hong Kong
Financial Reporting Standards as they relate to: Investment Property
3.06.01 Describe the scope and definition of an investment property
3.06.02 Apply the recognition and measurement principles in respect of investment property
3.06.03 Account for investment property under cost model and fair value model
3.06.04 Consider the situation when a property can be transferred in and out of the investment
property category
3.06.05 Evaluate the impacts on transferring an investment property from other categories of
property holdings and advise on the accounting treatments
3.06.06 Prepare and appraise disclosure in respect of investment property
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OPENING CASE
DRAGONFLY DEVELOPMENT LIMITED
D ragonfly Development Limited (Dragonfly) is a Hong Kong-based property development
and investment company that:
• Develops and redevelops property for sale as office buildings or residential dwellings;
for use as hotels it operates; for use as administrative offices; and for rental as shops,
offices, or luxury private residences;
• Manages properties it leases to tenants and car parks; and
• Provides a range of property-related services to lessees, such as maintenance, cleaning,
security and facility management.
Dragonfly’s operations are vertically integrated, from land acquisition, project planning,
project management, material sourcing and construction through to marketing and sales (for
properties developed for sale) and property management (for property developed for rental).
Dragonfly holds various types of property, including:
• Undeveloped land, some holdings of which were acquired for a particular purpose and
other holdings are held for a purpose yet to be determined;
• Construction work in progress in relation to properties held for sale in the ordinary
course of business and properties to be held for rental or use as a hotel; and
• Completed properties, some held for sale in the ordinary course of business, some held
for rental as shops, offices, or private residences, and others held for use as a hotel.
Some of its properties have multiple uses. For example, some buildings include shops
leased on the lowest levels; offices leased on the middle levels; and residential dwellings on the
upper levels, some of which are sold and others of which are leased.
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OVERVIEW
Investment property is property held to earn rentals, for capital appreciation or both. It
generates cash flows largely independently of the entity’s other assets. Some entities managing
investment property acquire land and develop part of it for sale in the ordinary course of
business and hold the remainder for investment through leasing it out to earn rental income,
that is, not all their properties are investment properties. In addition, entities with investment
property often generate income from property-related services such as cleaning and security.
In this chapter, you will gain an understanding of the types of assets within the scope
of HKAS 40 Investment Property, the recognition criteria for owned investment property and
how investment property is measured at recognition. You will also gain an understanding of,
subsequent to initial recognition, how investment property may be measured, how to account
for remeasurements of investment property and when and how to account for transfers of
property between investment property and other categories of asset. Furthermore, you will
gain an understanding of the disclosures about investment property that HKAS 40 requires.
In our case study of Dragonfly Development Limited, its properties include undeveloped
land, construction work in progress and completed properties (land and buildings) held for sale,
occupation by Dragonfly or rental to others.
Throughout this chapter, examples are provided regarding Dragonfly’s properties
and the issues that Dragonfly needs to consider in identifying, and accounting for, its
investment properties, and accounting for transfers between investment property and other
categories of asset.
These examples provide a practical appreciation of how the requirements of HKAS 40 are
applied, including how to address the more complex questions that can arise in accounting for
investment property.
8 . 1 OVERVIEW
This chapter addresses the accounting for investment property in accordance with HKAS 40
Investment Property.
The principal issues in accounting for investment properties are:
• Determining when a property qualifies as investment property, owner-occupied
property or inventory;
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Investment Property
• Recognising investment properties and accounting for subsequent expenditures to
replace parts of an investment property;
• Determining the carrying amounts of investment properties, on initial recognition
and subsequently (including choosing the measurement model for subsequent
recognition); and
• Determining when a change in a property’s use occurs, giving rise to a transfer between
investment property and another category of asset (e.g. owner-occupied property or
inventory), and accounting for that change.
In this section, you will gain an understanding of the types of assets to which HKAS 40
applies and be introduced to some of the terminology relevant to applying the principles in
that HKFRS.
8.1.1 Scope
HKAS 40 applies to the recognition, measurement and disclosure of investment properties.
HKAS It does not apply to biological assets related to agricultural activity and mineral rights and
40.2, 4 reserves, such as oil, natural gas and similar non-regenerative resources.
The definition of investment property (see Section 8.1.2) excludes owner-occupied property
(which falls within the scope of HKAS 16 Property, Plant and Equipment or HKFRS 16 Leases) and
property held for sale in the ordinary course of business (which is classified as inventory and
falls within the scope of HKAS 2 Inventories).
8.1.2 Terminology
Over the course of this chapter, you will be introduced to terminology particular to HKAS 40.
However, it will be useful to understand some of the terms before going much further into
the chapter.
HKAS 40 defines investment property as ‘property (land or a building, part of a building,
or both) held (by the owner or by the lessee as a right-of-use asset) to earn rentals, for capital
appreciation, or both rather than for:
(a) use in the production or supply of goods or services or for administrative purposes; or
HKAS
40.5 (b) sale in the ordinary course of business’.
Land and/or buildings composing an investment property might be owned by the
entity or be the entity’s right-of-use asset as a lessee of the property (sometimes called
leased investment property in this chapter). An investment property might be leased out
by an entity as a lessor in an operating lease. This chapter sometimes calls investment
property leased out by the entity as a lessor under an operating lease that is leased-out
investment property.
If a property is not an investment property, it is usually either owner-occupied
property (defined in HKAS 40) or inventory, both of which are excluded from the scope
of HKAS 40.
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8.1.3 Classification of Property as Investment Property, Owner-occupied
Property or Inventory
Investment property is property held to earn rentals, for capital appreciation or both.
Therefore, it generates cash flows largely independently of the entity’s other assets. In contrast,
owner-occupied property is property held for use in the production or supply of goods or
services or for administrative purposes, and it generates cash flows jointly with other assets
used in the production or supply process (or jointly with assets in activities administered
through using the owner-occupied property).
Examples of investment property are:
• Land held for long-term capital appreciation rather than for short-term sale in the
ordinary course of business;
• Land held for a currently undetermined future use;
• A building owned by the entity or held as a right-of-use asset by the entity as a
lessee and, in either case, leased out by the entity as a lessor under one or more
operating leases;
• A building that is vacant but held to be leased out by the entity as a lessor under one or
more operating leases; and
HKAS
40.8 • Property being constructed or developed for future use as investment property.
Key Learning Point
Investment property is property held to earn rentals, for capital appreciation or both.
Examples of items that are not investment property and, therefore, are outside the scope
of HKAS 40 are:
• Property intended for sale in the ordinary course of business or in the process of
construction or development for such sale (HKAS 2 Inventories applies to such property);
• Owner-occupied property to which HKAS 16 Property, Plant and Equipment or HKFRS 16
Leases applies, for example:
°° Property held for future use as owner-occupied property;
°° Property held for future development and subsequent use as owner-occupied
property;
°° Property occupied by employees (regardless of whether they pay rent at
market rates);
°° Owner-occupied property awaiting disposal; and
HKAS
40.9 • Property leased by the entity as a lessor to another entity under a finance lease.
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Investment Property
In the Opening Case, Dragonfly holds both types of property. It holds properties for
rental as shops, offices or luxury private residences, and it holds hotels, car parks and its own
administrative offices for use in the supply of services or for administrative purposes.
If an entity holds property leased to, or occupied by, its parent or another subsidiary, the
property does not qualify as an investment property in the consolidated financial statements
because the property is owner-occupied from the perspective of the group. The property is an
investment property from the perspective of the entity that holds it if it meets the definition of
investment property in HKAS 40 (i.e. it is held to earn rentals, for capital appreciation, or both)
HKAS in which case that entity classifies the property as investment property in its individual financial
40.15 statements.
8.1.3.1 Dual-purpose Properties
If properties include portions with different purposes (i.e. some are investment property and
others are owner-occupied property), the entity accounts for those portions as follows:
• If those portions could be sold separately (or leased out by the entity as a lessor
separately under a finance lease), those portions are accounted for separately;
• If those portions could not be sold separately, the property is classified as investment
HKAS property only if an insignificant portion has the characteristics of owner-occupied
40.10 property. ‘Insignificant’ is not defined in HKAS 40 and, therefore, management must
apply judgement in determining a percentage threshold, which might be disclosed as a
significant judgement.
Key Learning Point
Portions of properties that could be sold separately (or leased separately under a finance
lease) are accounted for separately.
Apply and Analyse 1
One of the buildings called Prism Tower and owned by Dragonfly includes:
• Offices on the lower levels, a significant proportion of which are occupied by
Dragonfly as its own offices, and the remainder of which are leased out by
Dragonfly as a lessor under operating leases; and
• Residential dwellings on the upper levels, some of which are sold and others leased
out by Dragonfly as a lessor under operating leases.
Prism Tower was acquired by Dragonfly as a completed building. Therefore, no
portions of the tower held for sale have been developed by Dragonfly for the purpose of
such sale; that is, no portions of the tower are inventory.
In acquiring the tower, Dragonfly purchased strata titles created for each of the
residential dwellings on the upper levels and acquires a single title encompassing the
remainder of the tower. Each residential dwelling could separately be sold or leased out
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Apply and Analyse 1 (continued)
by Dragonfly as a lessor under a finance lease. Dragonfly’s practice of leasing out some
of those residential dwellings under operating leases does not affect Dragonfly’s ability to
have sold or leased out those dwellings under a finance lease or to do so at some future
time. In contrast, none of the offices in the tower could be sold separately, and the leases
of the offices are unable to meet the criteria for classification as a finance lease.
Determine which separate unit(s) of account should be identified by Dragonfly for
classifying the tower as investment property or owner-occupied property.
Analysis
In applying HKAS 40, the first step in addressing this question is identifying whether the
property includes different portions with different purposes. In this regard, Dragonfly’s
purpose for holding the residential dwellings and the offices it does not occupy is
to earn rentals. Therefore, those portions of the tower have the characteristics of
investment property. Dragonfly’s purpose for holding the offices it occupies is conducting
administration. Therefore, Dragonfly’s asset in relation to those offices has the
characteristics of owner-occupied property.
Because the tower includes different portions with different purposes, assessing
whether those portions could be sold separately (or leased out by Dragonfly as a lessor
separately under a finance lease) is necessary.
Each of the residential dwellings on the upper levels of the tower is subject to
a separate strata title and, accordingly, could be sold separately by Dragonfly. Each
residential dwelling can be treated as a separate unit of account for the purposes of
classification as investment property or owner-occupied property. However, because each
residential dwelling is held for the same purpose (i.e. capital appreciation realised through
sale without development or the earning of rental income), for practical purposes, all of
those residential dwellings could be aggregated as a single unit of account and would be
classified as investment property.
Because none of the offices in the tower could be sold separately and the leases of
the offices are unable to meet the criteria for classification as a finance lease, all of those
offices should be treated as a single portion of the tower for classification purposes. As
the owner-occupied offices are a significant portion of the entire suite of offices, the lower
portion of the town is classified as owner-occupied property.
Apply and Analyse 2
Another property held by Dragonfly is a shopping mall complex built around a ‘flagship’
heritage building that has been adapted for office space. Dragonfly leases out the shops in
the shopping mall under operating leases and occupies the heritage building office space
for its own administrative activities.
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Apply and Analyse 2 (continued)
Dragonfly has a right to use the heritage building (and the land on which it is situated)
under a long-term lease. As a lessee of that building, Dragonfly is unable to sell it or lease
it out in a finance lease. Dragonfly has the title to the remainder of the shopping mall
property, which it has the ability to sell in its entirety. Sale of individual stores (or entry into
finance leases of them as a lessor) is infeasible for Dragonfly because it holds a single title
to the shopping mall property and benefits from the flexibility to vary the shopping centre
layout periodically according to the characteristics of its most lucrative tenants.
The heritage building is integral to the shopping mall because its iconic status provides
a profile for the mall and creates an ambience that helps attract customers. It represents a
significant portion of the property.
Determine whether Dragonfly should classify and account for (either as investment
property or owner-occupied property):
• The heritage building, and the remainder of the shopping mall complex, as
separate portions of the property; or
• The entire shopping mall complex as a single unit of account.
Consequently, determine the classification of the shopping centre complex or, if
separate portions are identified, the classification of each portion.
Analysis
In applying HKAS 40, the first step in addressing this question is identifying whether the
property includes different portions with different purposes. So, the purpose of holding
the heritage building portion is owner occupation for administrative purposes. Therefore,
Dragonfly’s right-of-use asset in relation to the heritage building has the characteristics of
owner-occupied property. The remainder of the shopping mall complex is leased out by
Dragonfly as a lessor under operating leases, indicating its purpose is being held to earn
rentals. Therefore, the remainder of the shopping mall complex has the characteristics of
investment property.
Having determined that Dragonfly’s shopping mall complex includes different portions
with different purposes, assessing whether those portions could be sold separately (or
leased out by Dragonfly as a lessor separately under a finance lease) is necessary.
Because the heritage building portion could not be sold or leased out by Dragonfly as a
lessor under a finance lease, it should not be classified and accounted for separately from
the remainder of the shopping mall complex. The shopping mall complex (including the
heritage building) is a single unit of account for classification purposes. Under HKAS 40, the
shopping mall complex should be classified as investment property only if an insignificant
portion of that property has the characteristics of owner-occupied property. The heritage
building (which has the characteristics of owner-occupied property) represents a significant
portion of the shopping mall complex. Therefore, the shopping mall complex should be
accounted for entirely as owner-occupied property.
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8.1.3.2 Ancillary Services
If an entity holds property that would qualify as investment property but provides services to
the property’s occupants, the property is classified instead as owner-occupied property if those
services are significant to the arrangement as a whole as in these examples:
• An entity provides insignificant ancillary services to the property’s occupants when
it provides security and maintenance services to lessee occupants. Accordingly, the
property remains classified as investment property.
• An entity that owns and manages a hotel provides services to guests who are
significant to the arrangement as a whole. Accordingly, an owner-managed hotel is
classified as owner-occupied property. In this regard, if the owner of a hotel transfers
responsibilities to third parties under a management contract:
°° The ancillary services the owner provides to hotel occupants might be insignificant
to the arrangement, with the owner being, in substance, a passive investor; the
hotel would not be classified as owner-managed and would, therefore, qualify as
investment property; and
°° At the other end of the spectrum, the owner might simply have outsourced its
day-to-day functions while retaining significant exposure to variations in the cash
flows generated by the hotel’s operations. Therefore, the hotel would be classified
as owner-managed and would qualify as owner-occupied property.
In relation to hotels and other properties where the property’s holder provides ancillary
services to the property’s occupants, it may be difficult to determine whether the services are
so significant that the property fails to qualify as investment property (e.g. when the owner of a
hotel transfers responsibilities to third parties under a management contract, it might be
HKAS difficult to determine where along the spectrum the arrangement lies); judgement will be
40.11–13 required in classifying the property as investment property or owner-occupied property.
Key Learning Point
A property is classified as owner-occupied property when its owner provides ancillary
services that are significant relative to the arrangement as a whole.
Apply and Analyse 3
In relation to its various properties leased out to tenants as a lessor in operating leases,
Dragonfly provides a varying extent of ancillary services to different occupants:
• For Dragonfly’s ‘Category A’ dwellings, Dragonfly provides tenants with security and
maintenance services only; and
• For Dragonfly’s ‘Category B’ dwellings, Dragonfly provides tenants with cleaning,
laundry and medical services, and allows free access to gymnasiums operated by
the company.
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Apply and Analyse 3 (continued)
In relation to Dragonfly’s Category A and Category B dwellings, determine whether
the extent of the ancillary services provided to the occupants results in the property being
classified as investment property or owner-occupied property.
Analysis
In classifying its Category A and Category B dwellings as investment properties or
owner-occupied properties, Dragonfly needs to apply judgement for each category to
determine whether those services are significant to each arrangement. (Dragonfly treats
each contract as an arrangement.)
Dragonfly concludes the following:
• The services provided to tenants in its Category A dwellings are insignificant
to each arrangement, and therefore, those dwellings should be classified as
investment properties; and
• The services provided to tenants in its Category B dwellings are significant
to each arrangement, and therefore, those dwellings should be classified as
owner-occupied properties.
Knowledge Check Questions
Question 1
For each of the below categories of investment property, determine which HKFRS(s) applies.
Category of investment property (IP) Is the property leased out?
Owned IP Not leased out
Owned IP Leased out in an operating lease
Owned IP Leased out in a finance lease
Leased IP (right-of-use asset) Not leased out
Leased IP (right-of-use asset) Leased out in an operating lease
Leased IP (right-of-use asset) Leased out in a finance lease
Question 2
Identify which one of the following properties should be classified entirely as owner-
occupied property under HKAS 40:
A An owner-occupied hotel in which each of the following occurs:
• The owner transfers responsibilities to a third party under a management contract;
• he third party bears the exposure to variations in cash flows resulting from
T
performing its promises, for example, it bears the exposure to changes in input
costs; and
• The ancillary services the owner provides to hotel guests are insignificant to the
arrangement as a whole.
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Knowledge Check Questions (continued)
BA
n apartment tower in which each apartment is subject to a separate strata title and
could be sold separately by the entity. The entity leases out the apartments as a lessor
in operating leases to earn rental income and provides ancillary services to lessees
that in some leases, are significant to each arrangement and in the other leases, are
insignificant to each arrangement.
C An office building in which some offices are leased out by the entity as a lessor in
operating leases to earn rental income and a significant portion of the building that
is occupied by the entity for administrative purposes. None of the offices leased out
by the entity in operating leases could be sold or leased out by the entity under a
finance lease separately from the portion of the building occupied by the entity for
administrative purposes.
D A property that is a parcel of land composed of adjacent allotments on separate
titles. The entire property was previously held for an undetermined future use. At the
reporting date, part of the parcel of land was being developed for sale in the ordinary
course of business separately from the remainder of the parcel, which continued to be
held for an undetermined future use.
8 . 2 RECOGNITION
HKAS 40 specifies that an owned investment property is recognised as an asset when, and only
HKAS when, the future economic benefits associated with the property will probably flow to the entity
40.16 and the property’s cost can be measured reliably.
The same recognition criteria apply to subsequent costs on additions to, replacements of,
HKAS or servicing of an investment property as those applying to costs incurred initially to acquire
40.17 the property.
The recognition criteria for an owned investment property in HKAS 40 are consistent with
the recognition criteria for an item of property, plant and equipment in HKAS 16 Property, Plant
and Equipment (see Chapter 7). For example, the costs of day-to-day servicing (repairs and
HKAS maintenance) of an investment property are excluded from the property’s carrying amount and
40.18 are recognised as an expense when incurred. Refer to Chapter 7 for more information about
applying these recognition criteria.
The recognition criteria in HKAS 40 applies to owned investment property because, as
HKAS specified in HKAS 40, an investment property held by a lessee as a right-of-use asset is
40.19A recognised in accordance with HKFRS 16 Lease.
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8 . 3 MEASUREMENT AT RECOGNITION
An owned investment property is measured initially at its cost, which includes its purchase
HKAS price and any directly attributable expenditure, which includes transaction costs, such as legal
40.20–21 fees and property transfer taxes.
The cost of an owned investment property is determined consistently with the cost of an
owner-occupied property (see Chapter 7). For example:
• The cost of an owned investment property excludes the following:
°° Start-up costs unless they are necessary to bring the property to the condition
necessary for it to be capable of operating in the manner intended by management,
such as costs of advertising newly constructed rental accommodation for lease;
°° Operating losses incurred before the investment property achieves the planned
level of occupancy; and
HKAS °° Abnormal amounts of wasted material, labour and other resources incurred in
40.23 constructing or developing the property; and
• Although the cost of an investment property acquired through an exchange of
non-monetary assets is typically measured at fair value, in limited circumstances, the
property’s cost is measured at the carrying amount of the asset given up in exchange.
These circumstances occur when:
°° The exchange transaction lacks ‘commercial substance’; or
HKAS °° Neither the asset received nor the asset given up in exchange has a reliably
40.27–29 measurable fair value.
The initial measurement of leased investment property held as a right-of-use asset by the
entity as a lessee is determined in accordance with HKFRS 16 Leases (see Chapter 9).
8 . 4 MEASUREMENT AFTER RECOGNITION
An entity chooses the fair value model or the cost model to measure all its investment
properties after initial recognition. This accounting policy option is discussed in Section 8.4.1.
The cost model and fair value model are discussed in Sections 8.4.2 and 8.4.3, respectively.
8.4.1 Accounting Policy
HKAS An entity chooses the fair value model or the cost model to subsequently measure its
40.30 investment properties (whether owned or leased) after initial recognition. An entity may choose
a different subsequent measurement model from that applied to all other investment
properties for investment properties backing liabilities that pay a return linked directly to the
HKAS fair value of, or returns from, specified assets including those investment properties. This can
40.32A–32B occur with investment funds or some insurance contracts.
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In practice (such as by closed property trusts) and where permitted by HKAS 8 Accounting
Policies, Changes in Accounting Estimates and Errors (see Chapter 16), an entity may change its
accounting policy for investment property from the cost model to the fair value model after
applying the cost model for one or more periods. The timing of this change is usually after the
fair value of investment property exceeds its carrying amount. The initial choice of the cost
model may have been motivated by a desire to avoid expensing substantial transaction costs
that would not have been reflected in the investment properties’ fair value at acquisition.
HKAS Although a change from the fair value model to the cost model is not explicitly prohibited,
40.31 HKAS 40 clarifies that the prohibition would unlikely be permitted under HKFRSs.
Regardless of the measurement model adopted, if the present value of an entity’s cash
outflows on an investment property (excluding payments relating to recognised liabilities) is
expected to exceed the present value of cash inflows from that property, the entity applies
HKAS HKAS 37 Provisions, Contingent Liabilities and Contingent Assets to determine whether it needs to
40.52 recognise a liability and how to measure such a liability (see Chapter 18).
8.4.2 Cost Model
If an entity chooses to apply the cost model to its investment properties, it will apply the
requirements for the cost model in HKAS 16 Property, Plant and Equipment (see Chapter 7).
Apply and Analyse 4
Clocktower Limited (Clocktower) self-constructed an office building, which it completed
on 31 December 20X0 and, as a lessor, leases out to a tenant under an operating lease.
Clocktower adopts the cost model to measure its investment properties and depreciates
the components of the building on a straight-line basis. The cost, useful life and residual
value for each significant component of the building are set out in the table below.
Component Cost Useful life Residual value
HK$’000 (Years) HK$’000
Foundations 50,000 50 –
Exterior walls 40,000 35 5,000
Interior walls, ceiling and windows 25,000 15 –
Roof 20,000 20 –
Lifts 10,000 20 –
Technical systems (air conditioning, water and 24,000 10 –
electrical)
Total 169,000
Calculate the carrying amount of the building at 31 December 20X5 and demonstrate
the accounting entry that records the building’s depreciation for the year ending
31 December 20X5.
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Apply and Analyse 4 (continued)
Analysis
The carrying amount of each significant component of the building and the carrying
amount of the building are determined as follows:
Component Cost Useful Residual Annual Carrying amount
life value depreciation at 31 Dec 20X5
(cost – residual (cost – 5 years of
value/useful life) depreciation)
HK$’000 (Years) HK$’000 HK$’000 HK$’000
Foundations 50,000 50 – 1,000 45,000
Exterior walls 40,000 35 5,000 1,000 35,000
Interior 25,000 15 – 1,667 16,665
walls, ceiling
and windows
Roof 20,000 20 – 1,000 15,000
Lifts 10,000 20 – 500 7,500
Technical 24,000 10 – 2,400 12,000
systems (air
conditioning,
water and
electrical)
Total 169,000 7,567 131,165
The building’s carrying amount as of 31 December 20X5 under the cost model would
be HK$131.165 million. During the year, Clocktower records the following accounting entry:
Debit Credit
HK$’000 HK$’000
Depreciation expense 7,567
Accumulated depreciation – building 7,567
(Depreciation of building for the year ending 31 December 20X5)
8.4.3 Fair Value Model
HKAS Under the fair value model, all of the entity’s investment properties (whether owned or leased)
40.33 are measured at fair value after initial recognition. The fair value of an investment property is
determined in accordance with HKFRS 13 Fair Value Measurement (see Chapter 4).
The unit of account for measuring the fair value of an investment property may be
an entire property or components of a property. For example, the unit of account for fair
value measurement might be a component when a component of an investment property
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(e.g. a lift in a building) is replaced or a component is added to an investment property
(e.g. a sauna is added to the common property in an apartment tower). The unit of account
at which fair value is measured will be influenced by the valuation techniques used under
HKFRS 13 to measure a particular property, that is, whether the market approach, cost
approach or income approach is used (see Chapter 4). For example, a replacement lift or an
added sauna might be valued using its current replacement cost (under the cost approach)
until the next valuation of the entire property is necessary. In contrast, if the property’s fair
value were measured using the income approach, if a component (such as the lift or sauna)
cannot generate separate cash inflows through sale or rental, measuring the fair value of the
component separately might be impracticable.
Some entities measure their owner-occupied properties under the cost model and measure
their investment properties under the fair value model. They regard measuring investment
properties at fair value through profit or loss as particularly important because investment
properties generate cash flows largely independently of the entity’s other assets and rental
income and changes in fair value are inextricably linked as integral components of the financial
performance of investment property.
The requirement to continue measuring investment property at fair value as it remains
HKAS investment property applies even if comparable market transactions become less frequent or
40.55 market prices become less readily available. Investment properties that would otherwise meet
the criteria for classification as ‘held for sale’ in HKFRS 5 Non-current Assets Held for Sale and
HKFRS Discontinued Operations are outside the scope of HKFRS 5’s measurement provisions if they are
5.5(d) measured under the fair value model. Such investment properties continue to be measured at
fair value, without deducting costs to sell (see Chapter 15).
Each fair value estimate of investment property must:
• Reflect rental income from current leases and other assumptions that market
HKAS participants would use when pricing investment property under current market
40.40 conditions; and
• Represent the fair value of the right-of-use asset, not the underlying property, for
lessees of investment property.
The fair value of investment property held by a lessee as a right-of-use asset reflects
expected cash flows, including variable lease payments expected to become payable. Those
expected cash flows reflect the term of the lease conveying that right of use rather than the
total economic life of the underlying property. Similarly, the fair value of that right-of-use asset
excludes any market premium attributable to the capacity of the underlying property to be sold
or redeployed after the lease expires.
When lease payments are at market rates, the fair value of an investment property held by
a lessee as a right-of-use asset at acquisition, net of all expected lease payments (including
those relating to recognised lease liabilities), should be zero. Therefore, remeasuring a
right-of-use asset from cost (as required on initial recognition by HKFRS 16 Leases) to fair value
(if the entity chooses the fair value model for its investment properties) should not give rise to
any initial gain or loss if that remeasurement occurred immediately after initial recognition.
However, if the entity chooses to apply the fair value model for all of its investment properties
HKAS
40.40A– after initially recognising a particular investment property held as a right-of-use asset, an initial
41, 50(d) fair value gain or loss would arise from a change in market rates of lease payments.
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In applying the fair value model, care must be taken not to double-count assets or liabilities
as in these examples:
• If lifts, air conditioning and other equipment that are integral parts of a building are
included in the fair value of the building as an investment property, they should not
also be recognised as separate assets;
• If an office is leased on a furnished basis, its fair value generally includes the fair
value of the furniture because the rental income factored into the office’s fair value
measurement relates to the furnished office. When furniture is included in the fair
value of an investment property, it is not recognised as a separate asset;
• The fair value of an investment property excludes prepaid or accrued operating lease
income because the entity recognises such an item as a separate liability or asset; and
• If a valuation of an investment property’s fair value is net of all payments expected to
be made, any recognised lease liability needs to be added back to that valuation when
measuring the property’s fair value. This is because the fair value of such a property
HKAS held by a lessee as a right-of-use asset reflects expected cash flows, including variable
40.50 lease payments expected to become payable.
Key Learning Point
To avoid double-counting, integral parts of an investment property included in the
valuation of the investment property are not recognised as separate assets.
Apply and Analyse 5
Assume instead that Clocktower adopts the fair value model to measure its investment
properties and, therefore, measures the self-constructed office building at fair value.
Assume also that the fair value of the office building, including all of its components
(e.g. lifts), was HK$142 million as of 31 December 20X4 and the fair value of the lift
component, an integral part of the building, of that fair value as of 31 December 20X4 was
measured as HK8.5 million.
Being an integral part of the building, the lift component is included in the fair value
of the building, rather than being accounted for as separate equipment. This avoids
double-counting of the lifts.
During January 20X5, the lifts required urgent replacement as a result of an
earthquake. The cost of their replacement was HK$12 million, and replacement was
completed by 31 January 20X5. Clocktower’s management concluded that the current
replacement cost of the lifts faithfully represented their share of the fair value of the
building as a whole.
On 31 December 20X5, the current replacement cost of the lifts was HK$13 million.
No other events affected the building’s fair value between 31 December 20X4 and
31 December 20X5.
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Apply and Analyse 5 (continued)
Determine the carrying amount (fair value) of Clocktower’s office building at 31 January
20X5 and 31 December 20X5.
Analysis
Upon replacing the lifts on 31 January 20X5, Clocktower should derecognise the carrying
amount of the replaced lift component of the building (HK$8.5 million) and recognise
the cost of that replacement component (HK$12 million). The cost of that replacement
component is the same as its current replacement cost as of 31 January 20X5, which
is used to measure that component’s fair value. In determining the fair value of the
building, Clocktower includes the lifts component as it is an integral part of the investment
property rather than account for as separate equipment. Therefore no additional entry
is needed to measure the replacement component at its fair value as of 31 January
20X5, and the building’s fair value as of 31 January 20X5 should be measured as
HK$142 million – HK$8.5 million + HK$12 million = HK$145.5 million.
The accounting entries as of 31 January 20X5 reflecting this analysis are:
Debit Credit
HK$m HK$m
Impairment loss (earthquake damage) 8.5
Investment property (office building: lift component) 8.5
(Write-off of lift component of investment property destroyed by earthquake)
Debit Credit
HK$m HK$m
Investment property (office building: lift component) 12
Cash 12
(Recognise cost of replacement lift installed)
On 31 December 20X5, Clocktower should measure the building’s fair value at
HK$146.5 million because the current replacement cost of the lift component increased by
HK$1 million since 31 January of that year (i.e. from HK$12 million to HK$13 million), and
no other events affected the building’s fair value. The increase in the building’s fair value
from HK$145.5 million to HK146.5 million (HK$1 million) should be recognised as a fair
value gain in profit or loss (see Section 8.4.3.1).
The accounting entry as of 31 December 20X5 reflecting this analysis is:
Debit Credit
HK$m HK$m
Investment property 1
Fair value gain (profit or loss) 1
(Remeasurement of investment property at the end of the financial year)
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Illustrative Example 1
Dragonfly applies the cost model to measure its owner-occupied property and the fair
value model to measure its investment property. On 31 December 20X7, Dragonfly
vacated an office building it entirely occupied for administrative activities for the
purpose of leasing out the building as a lessor in operating leases to earn rental income.
Consequently, the measurement model for the building changed from cost to fair value
as of that date. The cost-based carrying amount of the building’s fixtures and fittings
immediately before remeasuring the building to its fair value as of 31 December 20X7
was HK$12 million.
The fixtures and fittings were to be retained in the building when it was leased out to
tenants. The building’s fair value as of 31 December 20X7 was estimated as HK$330 million
using the ‘income approach’ in HKFRS 13 Fair Value Measurement (see Chapter 4). Under
that approach, the building’s fair value was estimated by reference to market rentals for
offices that include the fixtures and fittings, and therefore incorporated the value of those
fixtures and fittings. Consequently, to avoid double-counting assets, as of 31 December
20X7, the fixtures and fittings (HK$12 million) were derecognised and the office building
was remeasured to HK$330 million. The accounting entries for transfers between owner-
occupied property and investment property are set out in Section 8.5.
8.4.3.1 Fair Value Measurement and Changes
HKAS Under the fair value model, all changes in the fair value of investment property are recognised
40.35 as gains or losses in profit or loss for the period in which each change occurs.
8.4.3.2 Inability to Measure Fair Value Reliably
HKAS 40 includes a rebuttable presumption that the fair value of an investment property can
be measured reliably on a continuing basis. However, for an entity applying the fair value
model to its investment properties and in exceptional cases, evidence shows that when that
entity first includes an asset in investment properties, the asset’s fair value is not reliably
measurable on a continuing basis. This occurs when the variability in the range of reasonable
fair value measurements will be so great and the probabilities of the various outcomes so
difficult to assess, that the usefulness of a single measure of fair value is negated. This is the
case when, and only when the market for comparable properties is inactive (e.g. there are few
recent transactions, price quotations are not current or observed transaction prices indicate
HKAS that the vendor was forced to sell); alternative reliable measurements of fair value
40.48, 53 (e.g. measurements based on discounted cash flow projections) are unavailable.
Although the entity’s accounting policy remains that all its investment properties are
measured at fair value, the property in question is measured under the cost model in:
• HKAS 16 Property, Plant and Equipment for owned investment property (see Chapter 7); or
• HKFRS 16 Leases for leased investment property held as a right-of-use asset by the
entity as a lessee (see Chapter 9).
HKAS When HKAS 16 or HKFRS 16 is applied, the residual value of the investment property is
40.53 assumed to be zero.
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The preceding presumption can only be rebutted on initial recognition, that is, if an entity
previously measured an investment property at fair value, it should continue to do so even if
HKAS comparable market transactions become less frequent or market prices become less readily
40.55 available.
Investment Property Under Construction
The fair value of investment property under construction is often estimated using the residual
method, under which estimated future development costs plus an appropriate profit margin
are deducted from the estimated fair value of the completed property under current market
conditions using market data for comparable properties. However, the fair value of a particular
investment property under construction might not be reliably measurable on a continuing basis
during construction, for example, because the legally permissible uses of the property have yet
to be determined by the relevant government authority or because future development costs
cannot be measured reliably due to unique geological aspects of the property. In these
instances, the property is measured at cost until its completion or, if earlier, when its fair value
becomes reliably measurable. Once an entity determines that the fair value of an investment
HKAS property under construction is reliably measurable, it is prohibited to subsequently change its
40.53–54 conclusion.
When an entity completes the construction or development of a self-constructed
HKAS investment property that will be carried at fair value, any difference between its carrying
40.65 amount and fair value at the completion date is recognised in profit or loss. Typically, this
situation would arise where the fair value of an investment property under construction was
not reliably measurable on a continuing basis during construction.
Illustrative Example 2
Dragonfly is constructing a luxury apartment complex on a headland for intended
use as an investment property. Dragonfly acquired the land for the apartment
complex development on 1 February 20X0 (at a cost of HK$20 million) and carried out
construction during the remainder of the year ending 31 December 20X0. Construction
work in progress amounted to HK$7 million as of 31 December 20X0.
Dragonfly adopts the fair value model to measure all its investment properties. The
fair value of its investment properties under construction are estimated using the residual
method, which takes into account estimated future development costs because insufficient
comparable market data exists on which to base a reliable estimate of fair value using
other methods. However, shortly before the end of the first period in which Dragonfly held
the headland property (the year ending 31 December 20X0), Dragonfly’s project engineers
discovered a subterranean stream affecting the property. Consequently, the company is
presently unable to reliably estimate the costs to complete the project and, in turn, cannot
reliably measure the fair value of this particular investment property under construction.
It adopts the cost model in HKAS 16 Property, Plant and Equipment to measure the property
until sufficient information becomes available to enable reliable measurement of the
property’s fair value.
The accumulated directly attributable costs incurred by the end of the period
(31 December 20X0) amounted to HK$27 million. Depreciation is not recognised in relation
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Illustrative Example 2 (continued)
to the property because it is unavailable for use. Because of the increased, but presently
indeterminate, amount of future development costs, Dragonfly assesses whether the
investment property under construction might be impaired. Based on the originally
budgeted profit margin, the company concludes that, even in a worst-case scenario for the
additional costs, the property’s cost of HK$27 million is recoverable. The carrying amount
of the investment property as of 31 December 20X0 is HK$27 million.
A summary of the impact of classification of properties on subsequent measurement is
as follows:
• The primary significance of the distinction between investment properties and owner-
occupied properties is that:
°° Remeasurement increases for investment properties are always recognised in profit
or loss; whereas
°° Revaluation increases for owner-occupied properties are recognised in other
comprehensive income (as movements in revaluation surplus) except to the extent
that they reverse a revaluation decrease of the same asset previously recognised in
profit or loss; and
• The primary significance of the distinction between investment properties and
inventories is that:
°° Investment properties may be measured under the fair value model, with changes
in fair value recognised in profit or loss; whereas
°° Inventories cannot be revalued. Instead, they are measured at the lower of cost
and net realisable value, where net realisable value is effectively the recoverable
amount of inventory. Income arises from inventories when they are sold and
control of them passes to customers.
Knowledge Check Questions
Question 3
Identify which one of the following statements is not true under HKAS 40:
A Recognising that investment property fair value increases and decreases through
profit or loss in accordance with HKAS 40.35 means that, unlike with revaluations of
owner-occupied property recognised under HKAS 16 Property, Plant and Equipment,
there is no need to keep track of accumulated fair value gains and losses on a
property-by-property basis.
B An entity may conclude that an investment property’s fair value will not be reliably
measurable on a continuing basis because of a banking system crisis causing unprecedented
market volatility even though the market for comparable properties remains active.
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Knowledge Check Questions (continued)
C If an entity has adopted the fair value model for subsequent measurement of its
investment properties and determines, at initial recognition of an investment property
under construction, that the property’s fair value will be reliably measurable on a
continuing basis during construction, the property must continue to be measured at fair
value on an ongoing basis, meaning the assessment is irrevocable.
D If an entity adopted the fair value model for subsequent measurement of its investment
properties and determines, at initial recognition of an investment property under
construction, that the property’s fair value will not be reliably measurable on a continuing
basis during construction, the property is measured at fair value from the earliest time
its fair value becomes reliably measurable (which may occur during construction),
meaning the assessment is revocable.
Question 4
Watch Limited (Watch) adopts the fair value model to measure its investment property.
The investment property was purchased for HK$75 million on 1 January 20X1. The fair
value of the investment property at 31 December 20X1 and 31 December 20X2 was:
• 31 December 20X1 – HK$120 million
• 31 December 20X2 – HK$95 million
Determine the accounting entry that Watch records during the year ended
31 December 20X2.
A Debit Credit
HK$m HK$m
Investment property 20
Fair value gain (profit or loss) 20
B Debit Credit
HK$m HK$m
Fair value loss (profit or loss) 25
Investment property 25
C Debit Credit
HK$m HK$m
Investment property 25
Fair value gain (profit or loss) 25
D Debit Credit
HK$m HK$m
Fair value loss (other comprehensive income) 25
Investment property 25
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8 . 5 TRANSFERS
An entity may change its mind about how it uses a property and take steps to redeploy or
dispose of the asset, with or without modification. In these cases, HKFRSs require the entity
to reclassify the property so the financial statements faithfully depict the nature of each asset
held and the asset is measured under the rules appropriate to it. Consequently, the accounting
treatment of the asset might change.
To achieve this objective, an entity transfers a property between investment property and
another category of asset (e.g. owner-occupied property or inventory) in either direction when
HKAS and only when there is evidence of a change in the property’s use and that change in use
40.57 causes the property to meet, or cease to meet, the definition of investment property.
Evidence of a change in a property’s use and the accounting treatments of transfers between
investment property and either owner-occupied property or inventory is discussed in Section 8.5.1.
Key Learning Point
In certain circumstances, an entity may transfer a property between investment property
and another category of asset.
8.5.1 Evidence of Change in Use and Accounting Treatments
Examples of evidence of a change in a property’s use include:
For a change in use to investment property
• The end of owner occupation (transfer from owner-occupied property); and
• Inception of an operating lease to another party by the entity as a lessor (transfer from
inventories).
For a change in use from investment property to owner-occupied property or inventory
• The commencement of owner occupation, or of development with a view to owner
occupation (transfer to owner-occupied property); and
• Commencement of development with a view to sale (transfer to inventories).
These examples are not an exhaustive list of the events that provide evidence of a change
HKAS in use of a property. In isolation, a change in management’s intentions for the use of a property
40.57 does not provide evidence of a change in use.
When an entity decides to dispose of an investment property without development, it
HKAS continues to treat the property as an investment property until it is derecognised and does not
40.58 reclassify it as inventory.
8.5.1.1 Accounting Treatment of Reclassification
When an asset is transferred into or out of investment property, its measurement model is
conformed at the date of transfer to that of the asset category into which the asset is transferred:
• In the case of property, plant and equipment, the cost model or revaluation model,
following that adopted for the class of assets it now belongs to;
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• In the case of inventory, the lower of cost and net realisable value; and
• In the case of investment property, whichever of the cost model or fair value model was
adopted for all investment properties.
The accounting requirements in HKAS 40 for transfers into or out of investment property
specify how an entity achieves this basic principle. Those requirements are summarised in
Exhibit 8.1.
Category of asset Pre-transfer Post-transfer measurement model and
measurement accounting treatment of transfer
Pre-transfer Post-transfer
model
Owner-occupied Investment Cost Cost: Carrying amount of the property
property property remains unchanged (HKAS 40.59);
Fair value: (1) Update depreciation and any
impairment losses up to when the change
in use occurs, under the cost model, in
accordance with HKAS 16 or HKFRS 16
(as applicable); and
(2) Revalue the property to fair value upon
the change in use. The component of
comprehensive income arising from the
revaluation increase/decrease is determined
under the rules in HKAS 16 for revaluations
of property, plant and equipment (see
Chapter 7) (HKAS 40.61–62).
Revaluation Cost: HKAS 40 is silent about this
circumstance. HKAS 40 indicates that a
change from the fair value model to the cost
model for investment property would unlikely
be permitted by HKAS 8. Nonetheless, if such
a measurement model change were to occur
upon the transfer, accounting consistently,
with the required treatment for a transfer
from investment property measured on
the fair value model to property, plant and
equipment measured on the cost model,
would entail treating the asset’s fair value at
the date of change in use as its deemed cost
for subsequent accounting (HKAS 40.31);
Fair value: (1) Update depreciation and any
impairment losses up to when the change
in use occurs, under the revaluation model,
in accordance with HKAS 16 or HKFRS 16
(as applicable); and
(2) Revalue the property to fair value upon
the change in use. The component of
comprehensive income arising from the
revaluation increase/decrease is determined
under the rules in HKAS 16 for revaluations
of property, plant and equipment (see
Chapter 7) (HKAS 40.61–62).
EXHIBIT 8.1 Treatment of transfers between investment property and owned-occupied property,
and between investment property and inventory in either direction
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Category of asset Pre-transfer Post-transfer measurement model and
measurement accounting treatment of transfer
Pre-transfer Post-transfer
model
Inventory Investment Cost Cost: The asset’s carrying amount remains
property unchanged (HKAS 40.59).
Fair value: Remeasure the asset to fair value
upon the change in use. The resulting change
in carrying amount is recognised in profit
or loss (consistent with a sale of inventory)
(HKAS 40.63–64).
Investment Owner-occupied Cost Cost: Carrying amount of the property
property property remains unchanged (HKAS 40.59).
Revaluation: (1) Carrying amount of the
property remains unchanged when the
change in use occurs (HKAS 40.59); and
(2) Revalue the asset as owner-occupied
property at the end of the reporting period
in which the transfer occurred, in accordance
with HKAS 16.
Fair value Cost: The property’s fair value at the date
of change in use becomes the property’s
deemed cost (HKAS 40.60).
Revaluation: (1) HKAS 40 is silent about
this circumstance. There is no specific
requirement to update the property’s fair
value under the fair value model when the
change in use occurs; and
(2) The entity revalues the asset as owner-
occupied property at the end of the reporting
period in which the transfer occurred, in
accordance with HKAS 16.
Investment Inventory Cost Cost: Carrying amount of the property
property remains unchanged (HKAS 40.59).
Fair value Cost: The property’s fair value at the date of
change in use becomes the inventory item’s
deemed cost (HKAS 40.60).
EXHIBIT 8.1 (Continued)
When an asset’s measurement model changes from fair value to cost upon reclassifying the
asset, the entity does not reverse the cumulative amount of fair value gains or losses to measure
the asset as if it had always been classified in that manner. In accordance with HKAS 40, the
HKAS asset’s fair value at the date of change in use is the asset’s deemed cost for subsequent
40.60 accounting.
Apply and Analyse 6
Dragonfly operated a building as an owner-managed hotel as of 31 December 20X2.
Dragonfly classified the hotel building as an owner-occupied property as of that date
because, being owner-managed, the building was held for use in the supply of services
to customers. It carried the building on the cost model. The building had a cost of HK$90
million, a useful life of 40 years and a residual value of HK$10 million. Dragonfly used
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Apply and Analyse 6 (continued)
the straight-line method of depreciation for the building. As of 31 December 20X2, after
20 years of use, the building’s carrying amount was HK$50 million (calculated as HK$90
million – ((HK$90 million – HK$10 million) x (20 ÷ 40 years))).
On May 20X3, the management of Dragonfly formally decided to convert the building
to apartments that would be leased out by the entity as a lessor in operating leases to
earn rental income. On 30 June 20X3, the hotel ceased operations, and on 7 July 20X3, the
company vacated occupancy of the hotel. The conversion works were carried out from
July to November 20X3, at a cost of HK$40 million, and on 31 December 20X3, several
operating leases over the building’s apartments incepted. Dragonfly carried its investment
properties under the fair value model.
The fair value of the building on 31 May 20X3 was HK$55 million. On 30 June 20X3, it
was HK$56 million, and on 31 December 20X3, it was HK$108 million.
Analyse the information provided to determine if and when the building should be
transferred to investment property. Evaluate the impacts of any reclassification of the building
and demonstrate the accounting entries that reflect those impacts on Dragonfly’s building for
the year ending 31 December 20X3, including the effects of any reclassification of that building.
Analysis
On May 20X3, the management of Dragonfly formally decided to change the building’s
use from owner occupation to being held to earn rental income, that is, to change the
building’s use to an investment property.
HKAS 40.57 states that, in a property’s use, a change to ‘investment property’ requires
evidence of that change in use, and that, in isolation, a change in management’s intentions
for the use of a property does not provide evidence of a change in use. Therefore, the
decision by the management of Dragonfly on 31 May 20X3 is not treated as changing the
building’s use to an investment property at that time.
HKAS 40.57(c) states that an example of a change in use from owner-occupied property
to investment property is the end of owner-occupation. This event occurred on 7 July 20X3.
However, this example does not preclude earlier events from providing evidence of a change
in use. The cessation of the hotel’s operations on 30 June 20X3 provides evidence of a
change in use and should be treated as the time when the property transferred from owner-
occupied property to investment property. Although operating lease-outs of the building
by the entity as a lessor incepted on 31 December 20X3, after which rental income was
generated, the inception of these leases did not change the property’s use. This is because
the property transferred to investment property when the hotel ceased operations (on 30
June 20X3). The following paragraphs evaluate the impact of these developments and explain
the related accounting entries for the building for the year ending 31 December 20X3.
The building should be depreciated up to the date of change in use. Depreciation of
the building for the six-month period to 30 June 20X3 should be calculated as the building’s
cost minus residual value (i.e. HK$80 million) divided by 40 and multiplied by ½ because
the building has a useful life of 40 years and is depreciated on a straight-line basis.
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Apply and Analyse 6 (continued)
Therefore, the depreciation charge for the period until the change in the property’s use
should be HK$1 million. The building’s carrying amount under HKAS 16 on 30 June 20X3
would be calculated as the balance at 31 December 20X2 (i.e. HK$50 million) minus HK$1
million depreciation, that is, HK$49 million.
The building should then be revalued to fair value (using the entries specified by HKAS 16)
on 30 June 20X3. The fair value of the investment property on 30 June 20X3 was HK$56 million.
Therefore, the building should be revalued from HK$49 million to HK$56 million, a revaluation
increase of HK$7 million. Because the building had previously been measured under the cost
model, it had not previously been revalued downward through profit or loss. Therefore, the
credit entry corresponding to the revaluation increase for the building (HK$7 million) should be
recognised as an increase in revaluation surplus through other comprehensive income.
The cost of converting the building into an apartment tower (HK$40 million) incurred
during July to November 20X3 should be capitalised as part of the building’s carrying
amount. Consequently, the building should be carried at HK$96 million after the
conversion is completed.
As of 31 December 20X3, the building should be remeasured to its fair value (i.e. HK$108
million), resulting in an increase of HK$12 million over the building’s post-conversion carrying
amount. The credit entry corresponding to the HK$12 million fair value increase for the
building should be recognised as a gain in profit or loss in accordance with the fair value
model in HKAS 40.
The accounting entries are:
As of 30 June 20X3
Debit Credit
HK$m HK$m
Depreciation expense 1
Accumulated depreciation – building 1
(Depreciation of building up to the date of its transfer from owner-occupied
property to investment property)
Debit Credit
HK$m HK$m
Property, plant and equipment (building) 7
Revaluation surplus (other comprehensive income) 7
(Revaluation of owner-occupied property upon change in use)
Debit Credit
HK$m HK$m
Investment property (building) 56
Property, plant and equipment (building) 56
(Transfer of owner-occupied property to investment property)
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Apply and Analyse 6 (continued)
July to November 20X3 (composite entry)
Debit Credit
HK$m HK$m
Investment property 40
Cash 40
(Capitalise cost of converting building to an apartment tower)
As of 31 December 20X3
Debit Credit
HK$m HK$m
Investment property (building) 12
Fair value gain (profit or loss) 12
(Remeasurement of investment property at the end of the financial year)
Knowledge Check Questions
Question 5
Identify which one of the following events is not treated as a transfer of property between
investment property and another category of assets (in either direction) under HKAS 40:
A Superior dwellings developed for rental to tenants with minimal ancillary services
(e.g. security and maintenance services) commenced being marketed for rental under
leases by the entity as a lessor in which the lessee can choose to enter bundled contracts
including cleaning, laundry and medical services and free access to gymnasiums
operated by the entity.
B Unimproved land held for capital appreciation is marketed for immediate sale in its
present condition.
C Unimproved land held for undetermined purposes commenced to be developed for sale.
D An office building developed for sale is leased out by the entity as a lessor to generate
rentals under an operating lease.
Question 6
Identify which one of the following statements is true regarding the measurement
implications of a transfer between investment property and another category of property.
A When a property transfers from investment property measured under the fair value
model to inventory, fair value gains and losses since initial recognition of the property at
cost are reversed to measure the inventory at the lower of cost and net realisable value.
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Knowledge Check Questions (continued)
B When an owned-occupied property measured under the cost model in HKAS 16 Property,
Plant and Equipment transfers to investment property that will be measured under the
fair value model, it is revalued to fair value when the change in use occurs, with the
resulting revaluation increase or decrease recognised as a gain or loss in profit or loss
(for consistency with remeasurements of the entity’s other investment properties).
C When an investment property measured under the fair value model becomes owner-
occupied property that will be measured under the cost model in HKAS 16 or HKFRS 16
Leases, the property’s deemed cost for subsequent accounting in accordance with
HKAS 16 or HKFRS 16 is the property’s fair value at the date of change in use.
D When an investment property is transferred to property, plant and equipment, the entity
has an unrestricted choice of a subsequent measurement model (cost or revaluation) to
apply to that property.
Question 7
Moth Construction Limited (Moth) held a parcel of vacant land for a currently undetermined
future use at 31 December 20X1. The company adopts the fair value model to measure its
investment properties. As of 31 December 20X1, the land’s fair value was HK$46 million.
On 30 June 20X2, Moth commenced construction of a hotel building on the land,
which would be owner-managed upon completion. As of that date, the land’s fair value
was HK$48 million. Moth adopted the revaluation model to measure its owner-occupied
properties.
On 31 December 20X2, construction of the hotel building was incomplete. The
directly attributable construction costs incurred from 30 June 20X2 to 31 December 20X2
amounted to HK$82 million. The fair value of the property (land and partly constructed
hotel) as of 31 December 20X2 was HK$135 million.
Explain the impact of these events on the property held by Moth for the year
ended 31 December 20X2 in accordance with HKAS 40. Prepare the accounting entries
demonstrating these impacts (showing a cumulative entry for the construction work from
30 June 20X2 to 31 December 20X2).
Question 8
In relation to a building held by Dragonfly as an investment property and measured under
the fair value model, evaluate the implications under HKAS 40 of Dragonfly:
A Commencing development with a view to sale in the ordinary course of business; or
B Committing to a plan to sell the building immediately in its present condition (i.e. without
further development or redevelopment), initiating an active program to locate a buyer
and complete the sale plan and commencing active marketing of the building.
Compare and contrast the accounting implications of the scenarios in A and B.
In addition, evaluate how your answer under HKAS 40 would change in relation to
scenario B if the investment property building had been measured under the cost model.
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8 . 6 DISPOSALS
An investment property is subject to similar derecognition criteria as an item of property, plant
and equipment. Under HKAS 40, an investment property is derecognised when it is:
• Disposed of, by sale or entry into a finance lease by the entity as a lessor; or
HKAS • Permanently withdrawn from use and no future economic benefits are expected from
40.66–67 its disposal.
The date of sale of an investment property is the date the buyer obtains control of it
(see Chapter 5).
If an entity enters into a finance lease of an investment property as the lessor, or a
HKAS sale-and-leaseback in relation to an investment property, it applies HKFRS 16 Leases to account
40.67 for the transaction (see Chapter 9).
The gain or loss arising from disposing of, or retiring, an investment property is measured
as the difference between the net proceeds of disposal (if any) and the carrying amount of the
investment property (see Chapter 7).
Apply and Analyse 7
Dragonfly held a parcel of land for long-term capital appreciation as of 31 December
20X2. It adopted the fair value model for its investment properties and measured the land
(an investment property) at its fair value of HK$90 million as of 31 December 20X2.
Dragonfly sold the land on 30 November 20X3 for HK$100 million. On that date, the
buyer obtained legal title to the land, and Dragonfly obtained a present legal right to
payment of the contractual price; therefore, the buyer obtained control of the land. In
addition, Dragonfly incurred real estate agent’s fees of HK$3 million.
Evaluate the information provided and explain how to account under HKAS 40 for
the impact of these events on Dragonfly. Prepare the accounting entries demonstrating
these impacts.
Analysis
In accordance with HKAS 40, Dragonfly should derecognise the land, with a carrying
amount of HK$90 million, upon its disposal on 30 November 20X3 (the date on which the
buyer obtained control of the land). The resulting gain on disposal is calculated as the net
proceeds of disposal (i.e. sales proceeds of HK$100 million – estate agent’s fees of HK$3
million) minus the asset’s carrying amount (HK$90 million). Therefore, Dragonfly should
recognise a gain of HK$7 million in profit or loss for the year ending 31 December 20X3.
The accounting entries are:
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Apply and Analyse 7 (continued)
As of 30 November 20X3
Debit Credit
HK$m HK$m
Accounts receivable 100
Land 90
Cash (estate agent’s fee) 3
Gain on sale (profit or loss) 7
(Recognition of sale of land and gain on sale)
Knowledge Check Question
Question 9
Identify which one of the following statements is true under HKAS 40.
A Costs of disposal of an investment property are recognised as an expense.
B Compensation from third parties for a loss of an investment property (e.g. as a result of
a flood) is deducted from the expense recognised in respect of that loss.
C Entry into an operating lease-out of an investment property by the entity as a lessor is a
form of disposal of that asset.
D Entry into a finance lease-out of an investment property by the entity as a lessor is a
form of disposal of that asset.
8 . 7 DISCLOSURES
The disclosures immediately below apply to investment properties regardless of whether
they are measured under the fair value model or the cost model. Disclosures specifically
required when the entity adopts the fair value model are identified in Section 8.7.1. Disclosures
specifically required when the entity adopts the cost model are identified in Section 8.7.2.
The disclosures in this section apply in addition to:
• Those applicable to lessors or lessees of investment properties in HKFRS 16 Leases
(see Chapter 9);
• Those in HKFRS 13 Fair Value Measurement, for properties measured or disclosed
at fair value (e.g. the valuation techniques and inputs used to develop the fair
value measurements, including the relevant level of the fair value hierarchy; see
Chapter 4); and
• Those in HKAS 36 Impairment of Assets, for impaired properties measured under the
cost model (see Chapter 14).
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In view of the choice of measurement models for measuring investment properties,
HKAS HKAS 40 requires an entity to disclose whether it applies the fair value model or the cost model
40.75(a) to measure its investment properties.
In view of the subjective assessments sometimes required to distinguish an investment
property from owner-occupied property and inventory, HKAS 40 requires that, when
HKAS classification of a property between those asset categories is difficult, an entity discloses the
40.75(c) criteria it uses to distinguish investment property.
To enable users of financial statements to assess the nature and amount of all changes in
an entity’s investment properties during the period, an entity discloses a reconciliation of the
carrying amount of investment properties at the beginning and end of the period. Regardless of
which measurement model is adopted, that reconciliation discloses:
• Additions, separated into those resulting from: acquisitions through business
combinations; other acquisitions; and subsequent expenditure capitalised as part of
the asset;
• Assets classified as held for sale (or included in a disposal group classified as held
for sale) in accordance with HKFRS 5 Non-current Assets Held for Sale and Discontinued
Operations and other disposals;
• Net exchange differences arising on the translation of the financial statements from
the functional currency into a different presentation currency (including translation of a
foreign operation);
• Transfers to and from inventories and owner-occupied properties; and
HKAS
40.76, 79(d) • Other changes.
Other line items disclosed in the reconciliation (which are types of income and expense)
depend on the measurement model adopted. They are identified in Sections 8.7.1 and 8.7.2.
Other disclosures required for investment properties measured under either the fair value
model or the cost model are:
• Whether investment properties have been valued by an independent valuer who holds
a recognised and relevant professional qualification and has recent experience in the
location and category of the investment property being valued and, if so, the extent to
which the fair value of investment property is based on such a valuation (Section 8.7.2
will show that the fair value of investment properties must be disclosed if the entity
adopts the cost model);
• Rental income from investment property;
• Direct operating expenses (including repairs and maintenance) arising from investment
property, showing separately these amounts for properties that generated rental
income and those that did not generate any rental income during the period;
• The existence and amounts of restrictions on the realisability of investment property or
the remittance of income and proceeds of disposal; and
HKAS • Contractual obligations to purchase, construct or develop investment property or for
40.75(e)–(h) repairs, maintenance or enhancements.
HKAS 40 also requires disclosure of the cumulative change in fair value recognised in profit
or loss on a sale of investment property from a pool of assets in which the cost model is used
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(where an entity elects to apply the cost model to a pool of assets comprising all investment
property backing liabilities that pay a return linked directly to the fair value of, or returns from,
HKAS
specified assets including that investment property) into a pool of investment properties in
40.75(f)(iv) which the fair value model is used.
8.7.1 Fair Value Model
When an entity applies the fair value model to measure its investment properties, it also
discloses:
HKAS • Net gains or losses from fair value adjustments in its reconciliation of the carrying
40.76(d) amount of investment properties at the beginning and end of the period;
• A reconciliation between the external valuation and the valuation included in the
financial statements where an external valuation obtained was adjusted significantly
(e.g. to avoid double-counting), showing separately:
°° The aggregate amount of any recognised lease liabilities that have been
added back; and
HKAS
40.77
°° Any other significant adjustments; and
• The fair value of which cannot be measured reliably for those investment properties:
°° A description of the investment properties;
°° An explanation of why fair value cannot be measured reliably;
HKAS
40.78(a)–(c)
°° If possible, the range of estimates within which fair value is highly likely to lie; and
HKAS °° A reconciliation of the carrying amount of the investment properties at the
40.78 beginning and end of the period.
°° On disposal of those investment properties:
–– That the entity disposed of them;
–– The carrying amount of those investment properties when they were sold; and
HKAS
40.78(d) –– The amount of gain or loss recognised on disposal.
8.7.2 Cost Model
In view of the need to exercise judgements and make assumptions about uncertain future
events when calculating depreciation in respect of investment property measured under the
cost model, an entity applying the cost model to investment properties discloses:
• The depreciation methods used;
• The useful lives or depreciation rates used;
• The depreciation for the period (within the reconciliation of the carrying amount: see
the following); and
HKAS
• The gross carrying amount and the accumulated depreciation (aggregated with
40.79(a)–(d) accumulated impairment losses) at the beginning and end of the period.
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When an entity applies the cost model to measure its investment properties, it must
also disclose:
• In its reconciliation of the carrying amount of investment properties at the beginning
and end of the period:
HKAS °° Depreciation; and
40.79(d)
(iv)–(v)
°° Recognised impairment losses and reversals of impairment losses.
• The fair value of the investment properties (the disclosure of fair value is encouraged,
but not required, by HKAS 16 for owner-occupied property measured under the cost
model. See Section 8.4.3 for reasons why fair value is considered particularly important
for investment properties). In some instances, it might be impossible to measure
reliably the fair value of investment property for disclosure purposes. In these cases,
the entity discloses:
°° A description of the investment property;
°° An explanation of why fair value cannot be measured reliably; and
HKAS
40.79(e)
°° If possible, the range of estimates within which fair value is highly likely to lie.
Apply and Analyse 8
Fanling Corporation (Fanling) owns and rents out an apartment tower investment property,
which it measures under the fair value model in HKAS 40. In its financial statements for
the year ended 31 December 20X2, in relation to the apartment tower, Fanling recognised
‘Building HK$80 million’. Fanling obtained a valuation of the tower from an independent
valuer, dated 31 December 20X3. The valuer applied the income approach in HKFRS 13 Fair
Value Measurement to measure the tower’s fair value, basing the estimate on the rents for
comparable apartment towers. The valuation report stated that:
• The valuation was based on an income capitalisation approach; and
• The significant unobservable inputs used in the valuation are an income
capitalisation rate of 2.25% and an expected occupancy rate of 92%.
Fanling measured the tower at the valuation provided by the valuer (HK$86 million) in
its draft financial statements for the year ended 31 December 20X3.
As the lessor in operating leases of the apartments in the tower, Fanling provided
ancillary services of security, maintenance and cleaning to the lessees of those apartments,
requiring it to apply judgement in determining whether the tower is an investment
property. Fanling proposes to disclose the following information about that judgement in
its financial statements for the year ended 31 December 20X3:
‘The company applies judgement to determine whether the ancillary services it provides
to lessees of tower apartments under its contracts with them (security, maintenance and
cleaning services) are insignificant to the arrangement as whole. That judgement focuses on
whether the ancillary services create significant exposure to the cash flows generated by the
company’s operations. Based upon the exercise of that judgement, the company concluded
the services are insignificant and the tower is an investment property’.
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Apply and Analyse 8 (continued)
Fanling has a loan with an outstanding principal of HK$30 million secured over the
building as of 31 December 20X3, whereby the lender has rights to satisfy the loan from
the proceeds from any sale of the building. In relation to the restriction over the building,
Fanling proposes to disclose the following information in its financial statements:
‘The tower with a carrying amount of HK$86 million is subject to a restriction under a
loan agreement whereby the lender is entitled to apply the proceeds from any sale of the
tower to extinguish the company’s loan’.
Required
(a) For Fanling’s financial statements for the year ended 31 December 20X3, appraise the
adequacy under HKAS 40 of its proposed disclosures about:
• Its exercise of judgement in classifying the tower as an investment property; and
• The restriction over the proceeds from any sale of the tower.
(b) Appraise the other information provided and:
• Propose disclosures that Fanling should make about the tower in its financial
statements under HKAS 40 and, based only on that information, HKFRS 13
Fair Value Measurement; and
• Identify which other items of information are needed to comply with the disclosure
requirements of HKAS 40.
Analysis
(a) Adequacy of proposed disclosures
Criteria for distinguishing investment property
HKAS 40.75(b) requires an entity to disclose, when classification is difficult, the criteria
it uses to distinguish investment property from owner-occupied property. Fanling’s
proposed disclosure describes the factors affecting the classification of the tower as
investment property or owner-occupied property. However, it does not disclose the
criteria (or criterion) Fanling used to determine the point at which the ancillary services
it provides to lessees as the lessor in operating leases would become significant to the
arrangement as a whole (thus leading to classification of the tower as owner-occupied
property). For example, a quantitative measure might be used as a criterion for this
purpose. If so, an additional disclosure along the following lines would be appropriate
(these metrics are hypothetical):
‘The company identifies ancillary services it provides to lessees as significant to
the arrangement as a whole when the sum of their stand-alone selling prices equals
or exceeds 10% of the aggregate of those values and the gross rental income from
a property. For the tower, the ancillary services’ aggregate value was 6.6% of the
combined total; therefore, the ancillary services were determined to be insignificant’.
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Apply and Analyse 8 (continued)
Disclosure of restriction over sale proceeds
HKAS 40.75(g) includes a requirement to disclose the existence and amount of
restrictions on the proceeds of disposal of an investment property. Fanling’s proposed
disclosure shows the carrying amount of the investment property subject to such a
restriction. However, to comply with HKAS 40, it also needs to disclose the amount
of the potential claim on the disposal proceeds (i.e. the outstanding loan principal of
HK$30 million).
(b) Other disclosures
Disclosures based on the information provided
Fanling applies the fair value model to measure the apartment tower.
Reconciliation of the tower’s carrying amount between the beginning and end of
the period:
HK$m
Beginning of the period 80
Fair value adjustment (gain: recognised in profit or loss) 6
End of the period 86
The apartment tower’s fair value of HK$86 million as of 31 December 20X3 is
based, without adjustment, on a valuation by an independent valuer who holds a
recognised and relevant professional qualification and has recent experience in the
location and category of that tower. The valuation:
• Was based on an income capitalisation approach, which capitalised the property’s
net income from the existing tenancies and took into account the reversionary
potential of the property after expiry of the current leases in which the company is
the lessor;
• Adopted a capitalisation rate derived by reference to the yields achieved from
analysis of recent comparable property investment transactions and encapsulates
future expectations of investors regarding income, capital growth and perceived
risks; and
• Included the following significant unobservable inputs:
°° An income capitalisation rate of 2.25%
°° An expected occupancy rate of 92%
Because of these significant unobservable inputs to the fair value estimate, the tower’s
fair value estimate is categorised at Level 3 of the fair value hierarchy in HKFRS 13 Fair
Value Measurement. This level remained unchanged from 20X2.
Some fair value estimates of investment properties would be categorised as Level 2
estimates, for example, where a direct market comparison approach is used by reference
to recent sales prices of comparable properties on a price-per-square-foot basis using
publicly available market data. For simplicity, assume that changes in unobservable inputs
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Apply and Analyse 8 (continued)
would not result in a significantly different fair value measurement in the context of the
disclosure requirement in HKFRS 13.93(h).
Other information required to be disclosed under HKAS 40
Information about the following would also need to be disclosed about the tower:
• Rental income from the tower for the period;
• Direct operating expenses for the tower, disclosed separately from direct operating
expenses for any investment properties that did not generate rental income during
the period; and
• Any contractual obligations at the end of the period for maintenance or
enhancement of the apartment tower.
Knowledge Check Question
Question 10
Palatial Enterprises Limited (Palatial) held an investment property throughout the current
period to earn rental income as a lessor through operating leases, and refurbished
the property during that period. Palatial adopts the fair value model for subsequent
measurement of its investment properties. Assume the following information in relation to
its refurbished investment property:
• Fair value at the beginning of the period: HK$100 million;
• Expenditure on refurbishment: HK$18 million;
• Carrying amount of parts of property replaced in refurbishment: HK$5 million;
• Rental income for the period: HK$14 million;
• Operating expenses for the period:
°° Direct (e.g. repairs and maintenance, insurance): HK$4 million; and
°° Indirect (e.g. share of general administration costs): HK$1 million; and
• Fair value at the end of the period: HK$124 million.
Advise the management of Palatial Enterprises which disclosures are required by
HKAS 40, and the relevant amount for each disclosure, regarding the information provided
for the refurbished investment property. Assume all amounts are material.
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SUMMARY
• Investment property is property (land, a building or part of a building, or both) held
(by the owner or by the lessee as a right-of-use asset) to earn rentals or for capital
appreciation or both.
• Owned investment property is recognised as an asset (at its cost) when and only when:
°° It is probable that the property will generate future economic benefits; and
°° The property’s cost can be measured reliably.
• An entity chooses the fair value model or the cost model to measure all its investment
properties after initial recognition:
°° Under the fair value model, investment properties are measured at fair value at each
reporting date, with changes in fair value recognised immediately as gains or losses in
profit or loss; and
°° Under the cost model, investment properties are measured at their original cost less
accumulated depreciation and any accumulated impairment losses in accordance with
the requirements of HKAS 16 Property, Plant and Equipment.
• If an entity holds leased investment property as a lessee, it applies the requirements
of HKFRS 16 Leases to the recognition and initial measurement of its right-of-use asset.
Subsequently:
°° If that entity applies the cost model to all its investment properties, the right-of-use asset
is measured in accordance with HKFRS 16; or
°° If that entity applies the fair value model to all its investment properties, the right-of-use
asset is measured at fair value in accordance with HKAS 40.
• An entity transfers a property to, or from, investment property when and only when:
°° There is a change in the property’s use; and
°° That change in use causes the property to meet, or cease to meet, the definition of
investment property.
• An investment property is derecognised when the asset is disposed of or is permanently
withdrawn from use and no future economic benefits are expected from its disposal.
°° The resulting gain or loss is recognised immediately in profit or loss, unless HKFRS 16
requires otherwise on a sale and leaseback.
• An entity’s disclosures about its investment properties include:
°° Whether it applies the fair value model or the cost model;
°° The criteria used to identify investment property when classification is difficult;
°° The amount of investment property and changes in that amount by source;
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°° Rental income from investment property; and
°° Direct operating expenses arising from investment property.
• If the entity uses the fair value model for its investment properties, it also discloses:
°° Fair value gains and losses; and
°° Information required by HKFRS 13.
• If the entity uses the cost model for its investment properties, it also discloses:
°° Some of the information required by HKAS 16 for property, plant and equipment; and
°° The fair value of investment property.
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MIND MAP
SCOPE RECOGNITION
All investment properties, including those Recognition criteria for owned investment
obtained as right-of-use assets under property
leases. Definition excludes • Probable future benefits
• Owner-occupied property • Cost is reliably measurable
• Inventories Apply recognition criteria to initial and
subsequent costs. Examples of
subsequent costs:
• Replacements of asset components
DISCLOSURES • Enhancements of assets
• Costs of day-to-day servicing
For investment properties, disclose (write-off to expense)
• The model for subsequent measurement
(fair value or cost)
• The amount and changes in amount
• Rental income INVESTMENT MEASUREMENT AT RECOGNITION
• Direct operating expenses PROPERTY
(HKAS 40) Cost
• Under fair value model: fair value
• Determined using policies for property,
gains/losses and HKFRS 13 disclosures
plant and equipment
• Under cost model: depreciation information
Choose measurement
model for measurement
after recognition
DERECOGNITION
Derecognise investment property‘s MEASUREMENT AFTER RECOGNITION
TRANSFERS
carrying amount when either For all investment properties*, apply either
• It is disposed of Transfer property to/from
investment property when Cost model
• It is permanently withdrawn from use • Measure properties at COST less
and no future benefits expected from there is a change in
property‘s use - Accumulated depreciation
its disposal - Accumulated impairment losses
• Other categories include
Gain/loss on derecognition recognised under HKAS 36
owner-occupied property
in profit or loss Fair value model
and inventory
Apply measurement rules • Remeasure properties to FAIR VALUE at
for transfer in HKAS 40 each period end, except when fair value
cannot be measured reliably
Measurement model after • Recognise all changes in fair value as
transfer depends on the model gains or losses in profit or loss in the
adopted for the class/category period of those changes
of assets into which the
property is being transferred
Answers to Knowledge Check Questions
Question 1
Category of investment Is the property Applicable HKFRS(s)
property (‘IP’) leased out?
Owned IP Not leased out HKAS 40.
Owned IP Leased out in an HKAS 40.
operating lease
Owned IP Leased out in a HKFRS 16: The investment property has been
finance lease disposed of and the entity’s interest in the
property is a lease receivable.
Leased IP (right-of-use asset) Not leased out The recognition and initial measurement
requirements in HKFRS 16 apply. The
subsequent measurement requirements
in HKAS 40 apply if the fair value model is
adopted; the subsequent measurement
requirements in HKFRS 16 apply if the cost
model is adopted.
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Category of investment Is the property Applicable HKFRS(s)
property (‘IP’) leased out?
Leased IP (right-of-use asset) Leased out in an The recognition and initial measurement
operating lease requirements in HKFRS 16 apply. The
subsequent measurement requirements
in HKAS 40 apply if the fair value model is
adopted; the subsequent measurement
requirements in HKFRS 16 apply if the cost
model is adopted.
Leased IP (right-of-use asset) Leased out in a HKFRS 16: The investment property has been
finance lease disposed of and the entity’s interest in the
property is a lease receivable.
Question 2
Answer A is incorrect. HKAS 40 indicates that, if an owner of a hotel transfers
responsibilities to third parties under a management contract and the ancillary services the
hotel owner provides are insignificant to the arrangement as a whole, the hotel owner is in
substance a passive investor in the hotel. HKAS 40 also indicates that where a hotel owner,
having contracted out responsibilities to third parties, nonetheless retains significant
exposure to variations in the cash flows generated by the hotel’s operations, the hotel
would be classified as owner-managed (i.e. the hotel owner is not in substance a passive
investor in the hotel). Under the fact pattern in A, the hotel owner is in substance a passive
investor in the hotel and the hotel qualifies as investment property.
Answer B is incorrect. Where ancillary services provided to lessees of dwellings in
operating leases to earn rental income are significant to each arrangement, the dwellings
have the characteristics of owner-occupied property; and where such services are
insignificant to each arrangement, the dwellings have the characteristics of investment
property. These two different types of property represent different portions of the
apartment tower. Because the portions could be sold separately by the entity, they are
classified and accounted for separately. Therefore, the dwellings with the characteristics
of owner-occupied property are classified as owner-occupied property, and the dwellings
with the characteristics of investment property are classified as investment property.
Consequently, the apartment tower should not be classified entirely as owner-occupied
property under HKAS 40.
Answer C is correct. The property is composed of two portions. The first portion is the
offices leased out by the entity as a lessor in operating leases to earn rental income,
which has the characteristics of investment property. The second portion is occupied
by the entity for administrative purposes and has the characteristics of owner-occupied
property. Because those portions could not be sold separately or leased out by the
entity as a lessor separately under a finance lease, the portions are not accounted for
separately under HKAS 40. HKAS 40 specifies that an indivisible property (for classification
purposes) is classified as investment property only if an insignificant portion of that
property has the characteristics of owner-occupied property. A significant portion
of the property is occupied by the entity for administrative purposes (i.e. has the
characteristics of owner-occupied property). Therefore, the entire property is classified as
owner-occupied property.
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Answer D is incorrect. Under HKAS 40, land held for a currently undetermined future use
has the characteristics of investment property, and property in the process of development
for sale in the ordinary course of business has the characteristics of inventory. At the
reporting date, the property (a parcel of land) is composed of two portions with those
different characteristics. Because those portions could be sold separately, under the
principles in HKAS 40 they should be classified and accounted for separately. (HKAS 40
specifically refers to investment property portions and owner-occupied property portions.
Nevertheless, the logic of that guidance should also be applied where a portion of a
property has the characteristics of inventory.) Therefore, the portion of the property that
continued to be held for a currently undetermined future use should be classified and
accounted for as investment property, and the portion in the process of development
for sale in the ordinary course of business should be classified and accounted for as
inventory. No part of the property should be classified and accounted for as owner-
occupied property.
Question 3
Answer A is incorrect. Under HKAS 16 Property, Plant and Equipment, tracking accumulated
revaluation gains and losses on an asset-by-asset basis is necessary because the treatment
of revaluation increases and decreases depends, in part, upon whether they reverse
previous revaluation decreases and increases. In contrast, all investment property fair
value increases and decreases are recognised in profit or loss (in accordance with HKAS
40.35), regardless of whether (and in which direction) the investment property has
previously been remeasured. Therefore, for investment properties, there is no need to
keep track of accumulated fair value gains and losses on a property-by-property basis.
Therefore, the statement in A is true.
Answer B is correct. It is untrue that HKAS 40 permits an entity to conclude that an
investment property’s fair value will not be reliably measurable on a continuing basis in
any circumstance in which the market for comparable properties is active. HKAS 40.53
identifies an inactive market for comparable properties as an essential feature of an
inability to reliably measure an investment property’s fair value on a continuing basis.
Volatility of fair values is not an indicator of unreliable measurement.
Answer C is incorrect. HKAS 40.53B states that the presumption that the fair value of
investment property under construction can be measured reliably can be rebutted
only on initial recognition. If an entity has adopted the fair value model for subsequent
measurement of its investment properties and determines, at initial recognition of an
investment property under construction, that the property’s fair value will be reliably
measurable on a continuing basis during construction, HKAS 40 requires the property to
be measured at fair value on an ongoing basis. Therefore, the statement in C is true.
Answer D is incorrect. HKAS 40.53 states that, if an entity adopts the fair value model
for subsequent measurement of its investment properties and determines, at initial
recognition of an investment property under construction, the property’s fair value
will not be reliably measurable on a continuing basis during construction, the property
is measured at cost until the earlier of its fair value becoming reliably measurable or
construction being completed (if the entity expects the fair value of the property to be
reliably measurable when construction is completed). Therefore, the statement in D is true.
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Question 4
Answer A is incorrect. This is the cumulative fair value gain on the property since
acquisition.
Answer B is correct. The fair value movement from the investment property’s fair value at
the end of the previous reporting period (HK$25 million = HK$120 million – HK$95 million)
is recognised as a loss in profit or loss.
Answer C is incorrect. The fair value movement from the end of the previous reporting
period is a fair value loss because the fair value of the property has decreased from
HK$120 million to HK$95 million.
Answer D is incorrect. Under the fair value model, all fair value gains and losses on the
investment property are recognised in profit or loss.
Question 5
Answer A is incorrect. The services planned to be provided to tenants would have been
insignificant to each arrangement as a whole, and therefore, the entity should previously
have classified the property as investment property developed to generate rental income.
However, the bundled contracts that commenced being marketed involve the provision
of the entity’s services to tenants that are significant to each arrangement as a whole.
Therefore, the property should be transferred from an investment property to an owner-
occupied property, consistent with HKAS 40.11–12.
Answer B is correct. Because the property is not held for sale in the ordinary course of
business and will be held in an unimproved state until sold, it does not meet the definition
of inventories in HKAS 2 Inventories. HKAS 40.58 states that when an entity decides to
dispose of investment property without development, the property remains classified as
investment property until it is derecognised and is not reclassified as inventory. In addition,
if the investment property was measured under the cost model subsequent to initial
recognition and met the criteria for classification as an asset ‘held for sale’ in HKFRS 5
Non-current Assets Held for Sale and Discontinued Operations, the measurement
requirements of HKFRS 5 would be applied to the property (i.e. it would be carried at an
HKAS amount not exceeding its fair value less costs to sell: see Chapter 15) although the property
40.56(a) remains classified as investment property.
Answer C is incorrect. Under HKAS 40.8(b), the unimproved land should have been
classified as investment property while being held for an undetermined future use. When
development of the land for sale commenced, the property should be transferred to
inventory in accordance with HKAS 40.57(b).
HKAS Answer D is incorrect. When the office building was being developed for sale, it should
40.9(a) have been classified as inventory in accordance with HKAS 2 Inventories. When the purpose
of the property changed to being held to generate lease rentals, as evidenced by the
inception of operating leases in which the entity is a lessor, it should be transferred to
investment property in accordance with HKAS 40.57(d).
Question 6
Answer A is incorrect. When a property transfers from investment property measured
under the fair value model to inventory, restating the property to its original cost is
unnecessary. HKAS 40.60 states that, for a transfer from investment property carried
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at fair value to inventories, the property’s fair value at the date of change in use is the
property’s deemed cost for subsequent accounting in accordance with HKAS 2. Therefore,
the statement in A is not true.
Answer B is incorrect. When an owner-occupied property measured under the cost model
in HKAS 16 transfers to investment property measured under the fair value model, in
accordance with HKAS 40.61–62, the entity:
• Updates depreciation and any impairment losses up to when the change in use
occurs, in accordance with HKAS 16; and
• Remeasures the property to fair value upon the change in use. The component
of comprehensive income arising from the revaluation increase/decrease is
determined under the rules in HKAS 16 for revaluations of property, plant
and equipment (which include, in some circumstances, recognition in other
comprehensive income). Therefore, the statement in B is not true.
Answer C is correct. HKAS 40.60 states that, for a transfer from investment property
carried at fair value to owner-occupied property or inventories, the property’s deemed
cost for subsequent accounting in accordance with HKAS 16 Property, Plant and Equipment,
HKFRS 16 Leases, or HKAS 2 Inventories is the property’s fair value at the date of
change in use.
Answer D is incorrect. When an investment property is transferred to property, plant
and equipment, it will be included in a class of property, plant and equipment (e.g. land
and buildings). The subsequent measurement model adopted for that class of assets will
determine the subsequent measurement model to be applied to the transferred property.
Therefore, the statement in D is not true.
Question 7
Moth’s property (land) held for a currently undetermined future use at 31 December 20X1
should, in accordance with HKAS 40.8(b), have been classified as an investment property.
In accordance with HKAS 40.12, an owner-managed hotel is classified as owner-occupied
property. Evidence of the change in the use of Moth’s property, from investment property
to owner-occupied property, is the commencement of the hotel’s construction on
30 June 20X2.
HKAS 40 does not require Moth to revalue the property as of the date of change in use.
Instead, it is required to:
• Transfer the property from investment property to property, plant and equipment
as of 30 June 20X2 for its carrying amount of HK$46 million; and
• Measure the property as an item of property, plant and equipment from that date
onward. Consistent with the measurement of the company’s owner-occupied
properties on the revaluation model, the property (land and partly constructed
hotel) should be measured under the revaluation model in HKAS 16 Property, Plant
and Equipment from 30 June 20X2 onward (see the following).
Moth should capitalise the directly attributable construction costs incurred from
30 June 20X2 to 31 December 20X2 (HK$82 million) into the property’s carrying amount
in accordance with HKAS 16. Consequently, the cumulative entries to capitalise costs
should result in the property under construction being carried at HK$128 million
(i.e. HK$46 million + HK$82 million) immediately prior to the property’s revaluation on
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31 December 20X2. No depreciation should be recognised because the hotel is not yet
available for use.
On 31 December 20X2, Moth should revalue the property to its fair value of HK$135
million. This would result in a revaluation increase of HK$7 million over its most recently
updated carrying amount (HK$128 million). In accordance with HKAS 16, the credit entry
corresponding to the HK$7 million revaluation increase should be a revaluation gain
(increase in revaluation surplus) recognised in other comprehensive income.
The accounting entries should be:
As of 30 June 20X2
Debit Credit
HK$m HK$m
Property, plant and equipment (land) 46
Investment property (land) 46
(Transfer of investment property to owner-occupied property)
30 June to 31 December 20X2 (composite entry)
Debit Credit
HK$m HK$m
Property, plant and equipment (hotel) 82
Cash 82
(Capitalise costs of constructing hotel)
As of 31 December 20X2
Debit Credit
HK$m HK$m
Property, plant and equipment (hotel) 7
Revaluation surplus (other comprehensive income) 7
(Revaluation of hotel (owner-occupied property) at the end of the financial year)
Because Moth adopts the fair value model for its investment properties and owner-
occupied properties, the most significant consequence of the transfer from investment
property to owner-occupied property is that remeasurement increases cease being
recognised in profit or loss and, instead, are recognised in other comprehensive income.
Although Moth is not required to, it could elect to remeasure the property to its fair
value as of the date of change in use (30 June 20X2), which was HK$48 million. This would
result in a remeasurement increase of HK$2 million (i.e. HK$48 million minus the previous
carrying amount, which was HK$46 million). Because the property would be remeasured
as an investment property, the fair value increase (HK$2 million) would be recognised
as a gain in profit or loss. Consequently, the revaluation increase of the owner-occupied
property as of 31 December 20X2 would be reduced by HK$2 million to HK$5 million. The
logic for taking this optional approach is that the entire amount of the property’s fair value
increase, while it was being held as an investment property, would be accounted for under
the fair value model, that is, recognised in profit or loss.
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Question 8
A. Commencing development with a view to sale in the ordinary course of business is
HKAS an event that provides evidence of a change in the building’s use from an investment
40.57(b) property to an item of inventory. Therefore, Dragonfly should:
• Remeasure the property to its fair value on the date of change in use (i.e. when
development commenced), with the fair value increase or decrease recognised
as a gain or loss in profit or loss;
• Transfer the building from investment property to inventory; and
• Measure the building as an item of inventory (i.e. at the lower of cost and net
realisable value) from the date of change in use onward. The building’s deemed
cost for that purpose is its fair value on the date of change in use.
The change in use triggers a remeasurement of the building to its fair value
through profit or loss. Apart from that, because the building’s deemed cost is its
fair value on the date of change in use, the change in use would only change the
building’s carrying amount if its net realisable value were less than that deemed cost
(fair value). However, after the change in use (transfer to inventory), that change
would cause fair value remeasurements of the building to cease.
B. Under HKFRS 5 Non-current Assets Held for Sale and Discontinued Operations,
committing to a plan to sell a non-current asset immediately in its present condition
(i.e. without further development or redevelopment), initiating an active program to
locate a buyer and complete the sale plan, and commencing active marketing of the
asset are the steps that qualify the asset as ‘held for sale’. An asset that is held for
sale and is within the scope of HKFRS 5 is measured at the lower of its carrying
amount and fair value less costs to sell. However, HKFRS 5 excludes from the scope
HKFRS of its measurement provisions non-current investment properties that are measured
5.5(d) under the fair value model in HKAS 40. Therefore, the building would continue to be
measured as investment property at its fair value through profit or loss. Dragonfly’s
actions in scenario B have no effect on the building’s carrying amount.
Based on these conclusions, the different events in scenarios A and B have
little, if any, effect on the carrying amount of the building when those events
occur. However, under scenario A, the building ceases to be remeasured to fair
value whereas, under scenario B, the building continues to be remeasured until
disposed of.
If the investment property building had been measured under the cost model,
the events in scenario B would have resulted in the building:
• Being classified as held for sale and within the scope of HKFRS 5, including the
measurement provisions of that HKFRS; and, therefore,
• Being measured at the lower of its cost model carrying amount and fair value
less costs to sell. For this purpose, the cost model carrying amount has no
further depreciation deductions after the building becoming held for sale,
consistent with HKFRS 5.25. This is because the accounting for an asset held for
sale is a process of valuation rather than allocation.
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Question 9
Answer A is incorrect. HKAS 40.69 specifies that gains or losses arising from the retirement
or disposal of investment property are determined as the difference between the net
proceeds of disposal and the asset’s carrying amount. Therefore, costs of disposal of an
investment property are netted against the proceeds of disposal rather than recognised
separately as an expense.
Answer B is incorrect. HKAS 40.73 specifies that compensation from third parties for a
loss of investment property is a separate economic event from the loss and should be
accounted separately from the loss. Therefore, under HKAS 40.72, the compensation is
recognised (on a gross basis) in profit or loss when it becomes receivable.
Answer C is incorrect. Entry into an operating lease-out of a property by the entity as a
lessor is an example given in HKAS 40.57(d) of evidence of a change in use from inventories
to investment property. It is not a form of disposal of an asset.
Answer D is correct. HKAS 40.67 identifies entry into a finance lease-out of an investment
property by the entity as a lessor as an example of a disposal of that property. The lessor
derecognises the asset and recognises a lease receivable in accordance with HKFRS 16
Leases because a finance lease transfers substantially all the risks and rewards incidental to
ownership of the underlying asset.
Question 10
We advise the following about the disclosure requirements in HKAS 40 pertaining to the
refurbished investment property carried under the fair value model. Where amounts
exist for other investment properties affected by these disclosures, the disclosures for
the refurbished investment property would be incorporated within the disclosures for all
investment properties.
For investment properties measured under the fair value model, HKAS 40.76 requires
disclosure of a reconciliation between the carrying amounts at the beginning and end of the
period (disclosing separately the beginning carrying amount (fair value) of HK$100 million,
and the ending carrying amount of HK$124 million, for the refurbished property). For the
refurbished investment property, HKAS 40.76 requires disclosure of the following movements
within the reconciliation (the specific sub-paragraphs are provided in parentheses):
HKAS • The addition resulting from the subsequent expenditure on the refurbishment,
40.76(a) disclosed separately from additions resulting from acquisitions. HKAS 40 does not
specify whether this addition (HK$18 million) should be disclosed net of the carrying
amount of the parts of the property replaced in the refurbishment (i.e. the amounts
HKAS derecognised: HK$5 million) or whether the carrying amount of the derecognised
40.76(g) parts should be disclosed separately under ‘other changes’. We recommend
disclosing separately the gross amount of the addition through refurbishment
(HK$18 million) and the carrying amount of the derecognised parts (HK$5 million)
but presenting them in a linked manner (e.g. showing a net sub-total of HK$13
million) in the reconciliation.
HKAS
40.76(d) • The net gain from the fair value adjustment during the period. This amount should
be calculated as: (the fair value at the end of the period (HK$124 million)) – (the fair
value at the beginning of the period (HK$100 million) + the capitalised
refurbishment cost (HK$18 million)) + (the carrying amount of the replaced parts
(HK$5 million)) = HK$11 million.
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HKAS 40.75(f)(i) requires disclosure of the amount recognised in profit or loss for rental
income from all investment properties. For the refurbished investment property, this
amount is HK$14 million.
HKAS 40.75(f)(ii) requires disclosure of the amount recognised in profit or loss for
direct operating expenses arising from investment property that generated rental
income during the period. For the refurbished investment property, this amount is HK$4
million. This disclosure needs to be made separately from the amount of direct operating
expenses arising from investment property that did not generate rental income during the
period. Only direct operating expenses require disclosure under HKAS 40.
Our advice relates only to the disclosure requirements in HKAS 40. Additional
disclosure requirements for the refurbished investment property are set out in HKFRS
13 Fair Value Measurement and in HKFRS 16 Leases (the latter in relation to the operating
leases of the investment property entered by the entity as a lessor).
EXAM PRACTICE
QUESTION 1
Dragonfly, a property development and investment company, has the following properties at
31 December 20X1 and 31 December 20X2:
Property Original cost Carrying amount as of
HK$m 31 December 20X1
HK$m
Office Tower A 82 96
Office Tower B 60 40
Office Tower C 95 95
Unimproved land at 44 52
31 December 20X1
The company adopts the cost model for owner-occupied property and the fair value
model for investment property. Its inventories are measured at the lower of cost and net
realisable value. It is assumed for simplicity that the net realisable value of inventories
exceeds their cost at each measurement date.
Each building has a useful life of 30 years. Owner-occupied buildings are depreciated on
a straight-line basis. The residual value of each depreciable asset is zero.
Part (a)–Classification and measurement as of 31 December 20X1
The use of each property on 31 December 20X1 was:
• Office Tower A: Leased out by Dragonfly as a lessor under an operating lease to
generate rental income; Dragonfly provides no significant services under the lease
agreement;
• Office Tower B: Occupied by the company as its head office;
• Office Tower C: Developed for sale in the ordinary course of business; and
• Unimproved land at 31 December 20X1: Held for a currently undetermined
future use.
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Required
Identify how each property would have been classified by Dragonfly as of 31 December
20X1, and the measurement basis underlying its carrying amount at that date assuming
HKFRSs were correctly applied to the property. Justify your conclusions.
Part (b)–Events occurring during the year ended 31 December 20X2
Office Tower A: Dragonfly’s lease-out of Tower A as a lessor expired on 15 June 20X2, and
the company moved its head office on 28 June 20X2 to that building (which has greater floor
space than Office Tower B) to accommodate its growing staff. The fair value of Office Tower
A on 28 June 20X2 was HK$100 million, and on 31 December 20X2 was HK$105 million. On
the date of its change in use, Tower A had a remaining useful life of 25 years.
Office Tower B: Tower B was vacated by Dragonfly on 28 June 20X2. It was refurbished from
July to August 20X2 at a cost of HK$20 million. Assume, for simplicity, that no parts of the
tower were replaced when it was refurbished. The tower was leased out by Dragonfly as a
lessor under an operating lease to earn rental income: the lease incepted on 15 September
20X2. The fair value of Office Tower B on 28 June 20X2 was HK$55 million, on 15 September
20X2 was HK$79 million and on 31 December 20X2 was HK$84 million.
Office Tower C: Dragonfly leased out Tower C as a lessor under an operating lease to earn
rental income. The lease incepted on 30 April 20X2. The fair value of Office Tower C on 30
April 20X2 was HK$99 million, and on 31 December 20X2 was HK$114 million.
Land: Dragonfly’s management decided on 30 June 20X2 to develop for sale the land that
was unimproved on 31 December 20X1. Development for sale commenced on 15 July 20X2.
The land’s fair value on 30 June 20X2 was HK$56 million, and on 15 July 20X2, it was HK$57
million. On 31 December 20X2, the fair value of the property under development was
HK$118 million.
Required
Assume you are the audit senior on the Dragonfly audit. Analyse the potential changes in
use of the four properties and other economic events affecting these properties during the
financial year ending 31 December 20X2. Prepare a file note documenting your analysis
and conclusions regarding how to account for those events in accordance with HKAS 40,
and demonstrate your conclusions by presenting the accounting entries (including their
dates) for those events. Include the accounting entries for depreciation that arises for any
property measured under the cost model during the year ending 31 December 20X2 and any
remeasurements of property appropriate as of 31 December 20X2.
Show a composite accounting entry for the total cost of refurbishing Office Tower B
during July–August 20X2.
Part (c)–Operating lease-out of Office Towers B and C
Required
In relation to the fact pattern described in the preceding text, evaluate whether the
operating lease-out of Office Towers B and C by Dragonfly as a lessor changes the use of
those towers. If your conclusions for the two Towers are different, contrast them and give
your reasons.
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ANSWERS TO EXAM PRACTICE
QUESTION 1
Part (a)
Office Tower A would have been classified as an investment property as of 31 December
20X1 because the tower is leased out by Dragonfly as a lessor under an operating lease to
generate rental income and the company does not provide any significant services under the
lease agreement. Consistent with the measurement of the company’s investment properties
at fair value, tower A would have been measured at fair value as of 31 December 20X1.
Office Tower B would have been classified as an owner-occupied property as of 31
December 20X1 in accordance with the definition of owner-occupied property because
it was occupied as the company’s head office. Consistent with the measurement of the
company’s owner-occupied properties on the cost model, Tower A would have been
measured under the cost model as of 31 December 20X1, that is, at cost less accumulated
depreciation and any accumulated impairment losses.
Office Tower C would have been classified as inventory as of 31 December 20X1 because it
was developed (and held) for sale in the ordinary course of business. The property would
have been measured at the lower of cost and net realisable value as of 31 December 20X1.
The land holding that was unimproved at 31 December 20X1 would have been classified as
an investment property as of that date because HKAS 40 states that land held for a currently
undetermined future use is an example of investment property. Consistent with the
measurement of the company’s investment properties at fair value, the property would have
been measured at fair value as of 31 December 20X1.
Part (b)
Office Tower A
Office Tower A should be reclassified from investment property to owner-occupied property
on 28 June 20X2 upon the commencement of owner-occupation by the company on that date.
This is because the commencement of owner-occupation provides evidence that the tower is no
longer held for rentals and/or capital appreciation. Dragonfly should account for the transfer by:
• Revaluing the property to its fair value as of the date of change in use (i.e. HK$100 million).
The fair value increase is HK$4 million (i.e. HK$100 million minus the previous carrying
amount, which was HK$96 million). Because the tower is remeasured as an investment
property, the fair value increase (HK$4 million) is recognised as a gain in profit or loss;
• Reclassifying the revalued carrying amount of investment property as owner-occupied
property; and
• Measuring the property as an item of property, plant and equipment from that
date onward. Consistent with the measurement of the company’s owner-occupied
properties on the cost model, Tower A should be measured under the cost model from
28 June 20X2 onward. The property’s fair value as of the date of the change in use is its
deemed cost, that is, HK$100 million.
On the date of change in use of Tower A (28 June 20X2), the tower was ready for
immediate use (owner occupation) by Dragonfly. Therefore, applying the cost model to
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Tower A from 28 June 20X2 onward includes depreciating the tower from that date onward.
Depreciation for the tower for the six-month period from 28 June 20X2 to 31 December 20X2
should be calculated as (the tower’s deemed cost of HK$100 million minus residual value of
zero) divided by 25 and multiplied by ½ because the tower has a remaining useful life of 25
years and is depreciated on a straight-line basis. Depreciation is calculated using the tower’s
remaining useful life because a gross carrying amount, which is the subject of depreciation
over a depreciable asset’s total useful life (after deducting the residual value), is not
identified. Therefore, the depreciation charge for the part-year period after the change in
the property’s use should be HK$2 million. The tower’s carrying amount as of 31 December
20X2 under HKAS 16 would be calculated as the deemed cost as of 28 June 20X2 (i.e. HK$100
million) minus HK$2 million depreciation, that is, HK$98 million.
As of 28 June 20X2
Debit Credit
HK$m HK$m
Investment property 4
Revaluation gain (profit or loss) 4
(Revaluation of investment property upon change in use)
Debit Credit
HK$m HK$m
Property, plant and equipment (land and buildings) 100
Investment property 100
(Transfer of investment property to owner-occupied property)
As of 31 December 20X2
Debit Credit
HK$m HK$m
Depreciation expense 2
Accumulated depreciation – land and buildings 2
(Depreciation of building from the date of its transfer from investment property to
owner-occupied property)
Office Tower B
Office Tower B should be reclassified from owner-occupied property to investment property
on 28 June 20X2 when owner-occupation by the company ceased. This is because that event
provides evidence that the tower was held to generate rental income after refurbishment
and the change in use caused the office tower to meet the definition of investment property.
Dragonfly should account for the transfer by:
• Depreciating the tower up to the date of change in use. Depreciation for the tower for
the six-month period to 28 June 20X2 should be calculated as (the tower’s cost of HK$60
million minus residual value of zero) divided by 30 and multiplied by ½ because the
tower has a useful life of 30 years and is depreciated on a straight-line basis. Therefore,
the depreciation charge for the six-month period until the change in the property’s use
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FINANCIAL REPORTING
should be HK$1 million. The tower’s carrying amount under HKAS 16 on 28 June 20X2
would be calculated as the balance on 31 December 20X1 (i.e. HK$40 million) minus
HK$1 million depreciation, that is, HK$39 million;
• Revaluing the tower to fair value (using the entries specified by HKAS 16) on that
date. The fair value of the investment property on 28 June 20X2 was HK$55 million.
Therefore, the tower should be revalued from HK$39 million to HK$55 million, a
revaluation increase of HK$16 million. Because owner-occupied properties have
previously been measured under the cost model, the tower has not previously been
revalued downward through profit or loss. Therefore, the credit entry corresponding to
the revaluation increase for Office Tower B (HK$16 million) should be recognised as an
increase in revaluation surplus through other comprehensive income; and
• Reclassifying the revalued carrying amount of the owner-occupied property as
investment property.
The cost of refurbishing Office Tower B (HK$20 million) incurred during July–August 20X2
is capitalised as part of the tower’s carrying amount. Consequently, the tower is carried at
HK$75 million after the refurbishment is completed.
As of 31 December 20X2, Office Tower B should be remeasured to its fair value (i.e. HK$84
million), resulting in an increase of HK$9 million over the tower’s post-refurbishment carrying
amount. The credit entry corresponding to the HK$9 million fair value increase for Office
Tower B should be recognised as a gain in profit or loss.
As of 28 June 20X2
Debit Credit
HK$m HK$m
Depreciation expense 1
Accumulated depreciation – land and buildings 1
(Depreciation of building up to the date of its transfer from owner-occupied property to
investment property)
Debit Credit
HK$m HK$m
Property, plant and equipment (land and buildings) 16
Revaluation surplus (other comprehensive income) 16
(Revaluation of owner-occupied property upon change in use)
Debit Credit
HK$m HK$m
Investment property 55
Property, plant and equipment (land and buildings) 55
(Transfer of owner-occupied property to investment property)
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Investment Property
July – August 20X2 (composite entry)
Debit Credit
HK$m HK$m
Investment property 20
Cash 20
(Capitalise cost of refurbishing investment property)
As of 31 December 20X2
Debit Credit
HK$m HK$m
Investment property 9
Fair value gain (profit or loss) 9
(Remeasurement of investment property at the end of the financial year)
Office Tower C
Office Tower C should be reclassified from inventory to investment property on 30 April
20X2 because the inception of an operating lease by Dragonfly as a lessor to another party
provides evidence of a change in use from being held for sale in the ordinary course of
business to being held to generate rental income. The tower should be remeasured to its fair
value on that date, which was HK$99 million. Dragonfly should account for the transfer by:
• Remeasuring the tower from HK$95 million to HK$99 million on 30 April 20X2, a fair
value increase of HK$4 million. The credit entry corresponding to the HK$4 million fair
value increase for Office Tower C should be recognised as a gain in profit or loss; and
• Reclassifying the revalued carrying amount of the inventory as investment property.
As of 31 December 20X2, Office Tower C should be remeasured to its fair value (i.e.
HK$114 million). This would result in an increase of the tower’s carrying amount by HK$15
million from its remeasured carrying amount established on 30 April 20X2 (i.e. HK$99
million). The credit entry corresponding to the HK$15 million fair value increase for Office
Tower C should be recognised as a gain in profit or loss.
As of 30 April 20X2
Debit Credit
HK$m HK$m
Investment property 95
Inventory 95
(Transfer of property from inventory to investment property)
Debit Credit
HK$m HK$m
Investment property 4
Fair value gain (profit or loss) 4
(Remeasurement of property upon change in use)
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FINANCIAL REPORTING
As of 31 December 20X2
Debit Credit
HK$m HK$m
Investment property 15
Fair value gain (profit or loss) 15
(Remeasurement of investment property at the end of the financial year)
Land that was Unimproved at 31 December 20X1
The decision taken by the company’s management on 30 June 20X2 to develop the property
for sale is not evidence of a change in use, and no other evidence is mentioned in the fact
pattern at that time. Therefore, the property should not be reclassified from investment
property at that time. Instead, the property should be reclassified as inventories when
development with a view to sale commenced (on 15 July 20X2) because that event provides
evidence that the land is not being held for rentals and/or capital appreciation. Dragonfly
should account for this transfer by:
• Remeasuring the property to its fair value on the date of change in use. This would
give rise to a fair value increase of HK$5 million (being the fair value on 15 July
20X2 of HK$57 million minus the property’s carrying amount of HK$52 million as of
31 December 20X1). Because the property is remeasured as an investment property,
the fair value increase (HK$5 million) should be recognised as a gain in profit or loss;
• Reclassifying the remeasured carrying amount of the investment property as
inventory; and
• Measuring the property as an item of inventory from 15 July 20X2 onward. The
property should be measured at the lower of cost and net realisable value from that
date onward. HKAS 40 specifies that, for a transfer from investment property carried
at fair value to inventories, the property’s deemed cost for subsequent accounting
in accordance with HKAS 2 is the property’s fair value at the date of change in use
(i.e. HK$57 million). Therefore, the cost of the property for its measurement in
accordance with HKAS 2 should be measured at HK$57 million.
As of 15 July 20X2
Debit Credit
HK$m HK$m
Investment property 5
Fair value gain (profit or loss) 5
(Remeasurement of investment property upon change in use)
Debit Credit
HK$m HK$m
Inventories 57
Investment property 57
(Transfer of property from investment property to inventories)
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Part (c)
The answer given for Office Tower C in Part (b) states that it should be transferred from
inventories to investment property upon inception of an operating lease by Dragonfly as a
lessor to another party (on 30 April 20X2) because that event provides evidence of a change
in the property’s use. No prior event provides evidence of a change in use.
In contrast, the answer given in the preceding text for Office Tower B reflects that,
although an operating lease-out of it by Dragonfly as a lessor incepted on 15 September
20X2, this event does not provide evidence of a change in the property’s use. This is because
a prior event provided evidence of a change in the property’s use from owner-occupied
property to investment property. That prior event was the cessation of owner-occupation
(on 28 June 20X2) as part of a plan to relocate the company’s head office and then hold
Tower B to earn rental income after refurbishment.
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9
Leases
CHAPTER TOPIC LIST
9.1 Overview 9.3.4 Presentation
9.1.1 Scope 9.3.5 Disclosure
9.1.2 Terminology 9.4 Lessor
9.2 Identifying a Lease 9.4.1 Classification of Leases
9.2.1 Application of HKFRS 16 9.4.2 Finance Lease Accounting
9.2.2 Separating Components of 9.4.3 Operating Lease Accounting
a Contract 9.4.4 Disclosures
9.2.3 Lease Term 9.5 Sale and Leaseback Transaction
9.3 Lessee Accounting
9.3.1 Recognition 9.5.1 Assessing Whether the Transfer
9.3.2 Recognition Exemptions of the Asset Is a Sale
9.3.3 Measurement 9.6 Current Developments
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LEARNING OUTCOMES
PRINCIPAL LO3: EVALUATE AND ADVISE ON APPROPRIATE ACCOUNTING PRINCIPLES TO
ACCOUNT FOR COMPLEX BUSINESS TRANSACTIONS
LO3.08: A
ccount for, evaluate and advise on business transactions in accordance with
Hong Kong Financial Reporting Standards as they relate to: Leases
3.08.01 Appraise whether a contract is, or contains, a lease
3.08.02 Apply the principles regarding the separation of the components of a lease contract into
lease and non-lease elements
3.08.03 Apply the recognition exemptions applicable to lessees
3.08.04 Advise on the accounting treatments for leases from the perspective of the lessee, including
the initial and subsequent measurement of the right-of-use assets and lease liabilities
3.08.05 Apply the reassessment of the lease liability, including modification of leases
3.08.06 Apply the classification rules of leases as operating or finance leases from the perspective of
the lessor
3.08.07 Advise on the accounting treatments for leases from the perspective of the lessor, including
both finance and operating leases
3.08.08 Evaluate and account for sale and leaseback transactions
3.08.09 Prepare and appraise the disclosure in respect of leases
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Leases
OPENING CASE
HOME SUPPLIES
H ome Supplies Limited (Home Supplies) is a retail company offering a range of general
merchandise for the family home, including furniture, appliances and electronics. It has a
chain of 22 retail stores located in shopping malls throughout Hong Kong and mainland China,
and has in recent years, extended its international presence by opening stores in other parts of
Asia, including Singapore and Malaysia.
Each retail store is leased by Home Supplies from the shopping mall owners. Also, each
retail store is designed and fitted out the same way to ensure customers are familiar with the
placement of the product in all stores. Home Supplies has the exclusive use of all retail stores
for the duration of the respective leases and has control over the nature of the operations
during the period of use, including the products offered to customers.
As part of Home Supplies’ products, including furniture and electronics, such as televisions,
Home Supplies offers free next-day delivery and installation for all ‘large’ items. Home Supplies
has a warehouse in Hong Kong and mainland China that act as distribution centres, where
Home Supplies’ delivery trucks are loaded daily for delivery. Home Supplies’ delivery trucks are
used only for delivering ordered products and are parked overnight in the loading dock area
neighbouring the warehouse. Home Supplies is planning to provide delivery and installation
services in Singapore and Malaysia in the future.
In the last year, Home Supplies undertook steps to diversify and expand its operations
in two ways. First, Home Supplies purchased a parcel of land in Guangzhou to build a ‘mega’
store. The five-storey building will include Home Supplies’ full product range, as well as a food
eatery. Home Supplies will also use the store to introduce its new products, which will include
baby furniture, toys and video games. Second, Home Supplies introduced online shopping
for a range of appliances. The online shopping store is operated out of the mainland China
warehouse, which required a refurbishment to contain a designated office space where online
orders are received, packaged and distributed.
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OVERVIEW
In a lease arrangement, one entity (the lessee) promises to pay another entity (the lessor) for
the right to use the lessor’s asset for a specified period of time. How are leases recognised and
measured in general-purpose financial statements? Consider the case of Home Supplies, which
leases all its retail stores from shopping mall owners. When and how should Home Supplies
recognise, measure, present and disclose the assets arising from the leases (i.e. its rights to
use the retail stores) and the liabilities arising from the leases (i.e. its obligations to make lease
payments in return)? Should Home Supplies’ key financial ratios differ depending on whether
it owns the retail stores compared to leasing them? Should the same rules apply to all kinds
of leases, irrespective of the terms of the leases or the values of the underlying assets? For
example, if Home Supplies decides to lease low-value assets for a short period (e.g. computers
to operate its online business), should it be allowed to account for these leases differently from
the long-term leases of the higher value retail stores?
This chapter addresses the recognition and measurement of leases from the perspective
of the lessee and the lessor. You will gain an understanding of the complexities in recognising
and measuring leases in financial statements of lessees and lessors. By the end of this chapter,
you will have gained an understanding of when a lease exists and how leases are required
to be recognised, measured and presented in financial statements, together with the types
of information disclosed and how that helps ensure lessees and lessors provide relevant
information that faithfully represents lease agreements.
9 . 1 OVERVIEW
This chapter examines the definition, recognition, measurement, presentation and disclosure
requirements relating to lease agreements specified in HKFRS 16 Leases. HKFRS 16 is a
recent accounting standard, effective for annual reporting periods beginning on or after
1 January 2019.
The objective of HKFRS 16 is for lessees and lessors to provide relevant information in a
manner that faithfully represents lease arrangements. This information gives a basis for users
of financial statements to assess the effect that leases have on the financial position, financial
performance and cash flows of an entity.
Exhibit 9.1 provides a flowchart illustrating the process of lease accounting from the
lessee’s and the lessor’s perspectives. Both first identify whether a lease exists and then extract
its components from the lease agreement. The process then differs because a lessor is required
to classify a lease as a finance or as an operating lease and a lessee does not. Subsequently,
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Leases
Lessee Accounting Lessor Accounting
The identification of a lease and the components The identification of a lease and the components
of a lease contract of a lease contract
Classification of a lease
Recognition and initial measurement Recognition and initial measurement
Subsequent measurement Subsequent measurement
Presentation and disclosure Presentation and disclosure
EXHIBIT 9.1 Flowchart to illustrate lessee and lessor accounting
the lessee and lessor make decisions relating to recognition, initial measurement, subsequent
measurement and the presentation and disclosure of the impact of leases on their financial
position, financial performance and cash flows.
In this section, you will gain an understanding of the lease agreements to which HKFRS 16
applies and be introduced to some of the terminology to describe the parties to, and the key
terms of, a lease agreement.
9.1.1 Scope
HKFRS 16 applies to all leases except for:
• Leases to explore for or use minerals, oil, natural gas and similar non-regenerative
resources (HKFRS 6 Exploration for and Evaluation of Mineral Resources specifies the
accounting for rights to explore for mineral resources) (see Chapter 26);
• Leases of biological assets within the scope of HKAS 41 Agriculture held by a lessee
(see Chapter 26);
• Service concession arrangements within the scope of HK(IFRIC)-Int 12 Service Concession
Arrangements (see Chapter 26);
• Licences of intellectual property granted by a lessor within the scope of HKFRS 15
Revenue from Contracts with Customers (see Chapter 5); and
• Rights held by a lessee under licensing agreements within the scope of HKAS 38
Intangible Assets for items, such as motion picture films, video recordings, plays,
HKFRS manuscripts, patents and copyrights (see Chapter 11). For leases of other types of
16.3–4 intangible assets, a lessee may, but is not required to, apply HKFRS 16.
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9.1.2 Terminology
Throughout this chapter, you will be introduced to terminology pertinent to HKFRS 16. Before
proceeding further, it will be beneficial to understand some introductory terms associated with
a lease agreement relevant to the lessee, lessor or both (Exhibit 9.2).
Lessor
The lessor (i.e. the owner/supplier) is an entity that provides the right to use an underlying
asset for a period of time in exchange for consideration. How this arrangement is reflected
in the lessor’s financial statements depends on whether the lease is a finance lease (a lease
that transfers substantially all the risks and rewards incidental to ownership of an underlying
asset) or an operating lease (a lease that does not transfer substantially all the risks and
rewards incidental to ownership of an underlying asset)
Lessee
The lessee (i.e. the tenant/renter) is an entity that obtains the right to use an underlying
asset for a period of time in exchange for consideration. The lessee recognises for the
duration of the lease term a right-to-use asset in its financial statements, representing
its right to use the underlying asset for the lease term, and a lease liability that reflects the
obligation to make future lease payments in return for the right to use the underlying asset.
Lease
A lease is a contract, or part of a contract, that conveys the right to use an asset (the
underlying asset – The asset that is the subject of a lease, for which the right to use that asset
has been provided by a lessor to a lessee, e.g. a building) for a period of time in exchange
for consideration. A contract is an agreement between two or more parties that creates
enforceable rights and obligations.
The terms and conditions of a lease will normally include:
• An inception date – The earlier of the date of a lease agreement and the date of
commitment by the parties to the principal terms and conditions of the lease;
• A commencement date – The date on which a lessor makes an underlying asset
available for use by a lessee;
• A lease term – The non-cancellable period for which a lessee has the right to use an
underlying asset; and
• Details of the lease payments – The payments made by a lessee to a lessor relating
to the right to use an underlying asset during the lease term.
Each of these will have implications for the timing of recognition and amounts
recognised in the financial statements of the parties to the lease.
EXHIBIT 9.2 HKFRS 16 terminology
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Knowledge Check Question
Question 1
Identify which one of the following is a lease within the scope of HKFRS 16.
A A company enters into a contract with a dairy farmer to tend to the farmer’s herd of
cows and sell the milk produced for three years.
B A company enters into a contract with a landowner to gain permission to explore for oil
on the landowner’s land.
C A theatre company enters into an agreement with an American playwright to perform
the playwright’s play in the Asia-Pacific region.
D A company enters into a contract with a shopping centre operator to use a retail outlet in
the centre to sell the company’s goods for five years.
9 . 2 IDENTIFYING A LEASE
When a customer and supplier enter into a contractual arrangement, determining the nature of
the contract is important. By determining the nature of the contract, each party is better able to
identify its rights and obligations arising from the contractual relationship and how to account
for these rights and obligations. For example, if the supplier promises to transfer goods or
services to the customer, the obligation (to fulfil this promise and the revenue that is generated
as the promise is fulfilled) is to be accounted for under HKFRS 15. If, however, the supplier
(i.e. the lessor) promises the customer (i.e. the lessee) the right to use one of the lessor’s
assets for a period of time, HKFRS 16 will govern the terms of that contract. Given the different
accounting treatment for various contract types, the contracting parties must accurately
identify whether the contractual arrangement is, or contains, a lease.
9.2.1 Application of HKFRS 16
To determine whether HKFRS 16 applies, an entity must assess whether a contract to which it is
a party is, or contains, a lease. A contract is, or contains, a lease if the contract conveys the right
to control the use of an identified asset for a period of time in exchange for consideration. An
HKFRS entity makes this assessment at the inception (as distinct from at commencement) of a contract
16.9, 11 and again during the contract but only if the terms and conditions change.
An entity must, therefore, assess whether there is an identified asset; for which there is a
right to control its use and for a period of time.
For the purposes of the following discussion, the two parties to the contract are referred to
as the supplier (the potential lessor) and the customer (the potential lessee).
9.2.1.1 Identified Asset
HKFRS
16.B13 An identified asset can be explicitly or implicitly specified in a contract. An example of an
identified asset being implicitly specified is if the contract requires the supply of a motor vehicle
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of a particular make and model for use by the customer but does not require one particular
motor vehicle held by the supplier, as identified by registration number, to be the motor
vehicle supplied.
Furthermore, an identified asset can be a physically distinct portion of a larger asset (e.g. a
floor of a building). In the case of Home Supplies, it must determine whether each retail store it
occupies is an identified asset within each shopping mall, which it is likely to be. In contrast, a
capacity or portion of an asset that is not physically distinct (e.g. permission to sell from a
mobile cart in designated areas of a shopping mall) is not an identified asset for the purposes
of HKFRS 16 unless it represents substantially all of the capacity of the asset (e.g. the shopping
HKFRS
mall, which it is unlikely to be) and, as such, provides the customer with the right to obtain
16.B20 substantially all of the economic benefits from use of the asset.
If the supplier has the substantive right to substitute the asset at any time throughout the
period of use, it would also not be an identified asset for the purposes of HKFRS 16 because the
customer does not have the right to use the specific asset; rather, the customer has a right to
HKFRS
use an unspecified asset. Exhibit 9.3 outlines the criteria to be satisfied for a supplier to possess
16.B14 a substantive right of substitution.
Criteria (i) The supplier has the practical ability to substitute (ii) The supplier would benefit
alternative assets throughout the period of use economically from such asset
substitution
Definition The customer cannot prevent the supplier from The economic benefits of
substituting the asset with similar alternative assets substitution exceed the costs
readily available to the supplier or can be sourced of doing so
by the supplier within a reasonable time
EXHIBIT 9.3 Substantive right of substitution criteria
For example, consider a lease in which the shopping mall owner has a right to relocate a
retailer to another store within the mall if the mall owner is able to lease out the original store
to another retailer for a greater return. In this example, the shopping mall owner can substitute
alternative assets throughout the period of use because they have the right to move a lessee
to another store and benefit economically from such asset substitution, given their ability to
generate greater returns by doing so.
For the supplier’s substitution right to be substantive, it must exist for the duration of the
contract. For example, if the supplier can only substitute an asset after a future date or the
occurrence of a future event, the supplier’s substitution right will not be substantive. In
HKFRS
16.B15, addition, if the asset is to be replaced if it becomes faulty or a technical upgrade becomes
B18 available, this does not prevent the asset from being an ‘identified asset’.
As a practical expedient, there is a presumption in HKFRS 16 that if the customer cannot
HKFRS
readily determine whether the supplier’s substitution right is substantive or not, it is treated as
16.B19 being not substantive.
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Illustrative Example 1
Optical Solutions Limited (Optical Solutions) enters into a 10-year contract with Cabling
Communications Limited (Cabling Communications) for the right to use the full capacity
of eight of the 25 fibres within a fibre optic cable connecting Hong Kong and Singapore.
The eight fibres are dedicated solely to Optical Solutions’ data for the contract’s duration.
Cabling Communications has an obligation to substitute Optical Solutions’ fibres for
others within the fibre optic cable in the event of fault or damage.
The eight fibres constitute identified assets as they are explicitly specified in the
contract and are a physically distinct portion of a larger asset, being the fibre optic cable.
Moreover, Cabling Communications does not have a substantive substitution right because
substitution will only arise on the fibres becoming faulty or damaged.
Illustrative Example 2
OptiCom Limited (OptiCom) enters into a five-year contract with InfoSpeed Limited
(InfoSpeed) for the right to use 40% of the capacity of a fibre optic cable connecting
districts within Hong Kong.
The portion of the fibre optic cable that OptiCom has the right to use is not physically
distinct. As such, for it to constitute an identified asset, the portion of the fibre optic cable’s
capacity that OptiCom has the right to use (i.e. 40%) must represent substantially all of the
capacity of the fibre optic cable. Given 40% is less than half of the fibre optic cable’s capacity,
40% does not constitute ‘substantially all’. As such, an identified asset does not exist.
9.2.1.2 Right to Control Use
HKFRS Exhibit 9.4 outlines the criteria to be satisfied for a customer to possess a right to control the
16.B9 use of an identified asset.
Does the customer have the right to
substantially all of the economic benefits
from the use of the identified asset?
YES NO
Does the customer have the NO The customer does not have the
right to direct the use of right to control the use of
the identified asset? the identified asset
YES
The customer has the right to
control the use of the identified
asset
EXHIBIT 9.4 A customer’s right to control the use of an identified asset
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Exhibit 9.5 outlines what an entity is to consider in determining whether the ‘right to control
use’ criteria have been satisfied.
RIGHT TO ‘SUBSTANTIALLY ALL’ OF THE ECONOMIC BENEFITS:
• Professional judgement is required.
• In applying that professional judgement, a customer can derive economic benefits from use
of an asset either directly or indirectly (e.g. by using, holding or subleasing the asset).
• The economic benefits of an asset include its primary outputs (e.g. goods produced) and
by-products (e.g. renewable energy credits generated through the asset’s use), and other
HKFRS economic benefits from using the asset that could be obtained from a commercial transaction
16.B21 with a third party (e.g. subleasing the asset).
RIGHT TO DIRECT USE
A customer has the right to direct the use of an identified asset if:
• The customer has the right to direct how and for what purpose the asset is used throughout
the period of use; or
• The relevant decisions about how and for what purpose an asset is used are predetermined
and the customer:
(i) Has the right to operate the asset, or to direct others to operate the asset in a manner
that it determines, throughout the period of use, without the supplier having the right
to change those operating instructions; or
HKFRS (ii) Designed the asset, or specific aspects of the asset, in a way that predetermines how and
16.B24 for what purpose the asset will be used throughout the period of use.
Whether a customer has the right to direct how and for what purpose an asset is used, the
HKFRS emphasis is on whether the customer has decision-making rights to affect the economic
16.B25 benefits to be derived from use of the asset.
Examples of such decision-making rights include the customer’s right to change the:
• Type of output produced by the asset;
HKFRS • When and where the output is produced; and
16.B26 • Whether the output is produced and the quantity of that output.
Decision-making rights in relation to operating or maintaining the asset are not decision-making
HKFRS rights that grant the right to change how and for what purpose the asset is used.
16.B27
EXHIBIT 9.5 Considerations in determining whether the ‘right to control use’
criteria have been satisfied
In the case of Home Supplies, it has the right to substantially all the economic benefits
from using the retail space because it has exclusive use of a store for the lease’s duration.
Home Supplies also has the right to direct how and for what purpose the asset is used during
the lease because it decides the types of products sold, their sale price and the quantity of
inventory held.
If decisions about how and for what purpose an asset is used are predetermined, HKFRS 16
states the customer (i.e. the lessee) still has control over the use of the asset during its period
of use if:
• The customer has the right to operate the asset (or direct others to operate the
asset); or
• The customer designed the asset in a way that demonstrates he or she influenced how
and for what purpose the asset will be used
If the customer does not have the right to operate, or did not design, the asset, he or she
HKFRS
16.B29,
will not have the right to control the use of an asset. As a result, a lease does not exist. Rather, a
BC121–123 typical supply or service contract exists.
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Illustrative Example 3
Office Storage Limited (Office Storage) enters into a contract with Easy Removalists
Limited (Easy Removalists) for the use of a truck for one week to transport cargo from
Hong Kong to Shanghai. The terms of the contract, as negotiated by Office Storage and
Easy Removalists, specify the type of cargo permitted to be transported on the truck
for the one-week period, as well as the maximum distance that the truck can be driven.
Office Storage can choose the details of the journeys taken (e.g. route, rest stops), and is
responsible for driving the truck from Hong Kong to Shanghai (and return).
Because Easy Removalists and Office Storage negotiated the contract terms , which
outline the type of cargo permitted to be transported and the maximum distance to be
travelled for the one-week period, Office Storage does not have the (sole) right to direct
how and for what purpose the truck is used for that week. Instead, Office Storage and
Easy Removalists predetermined how and for what purpose the truck will be used (i.e. at
inception it was agreed on that the truck is to be used to transport specified cargo from
Hong Kong to Shanghai for a one-week period). However, because Office Storage has the
right to operate the truck throughout that one-week period (e.g. route, rest stops), it has
the right to direct the use of the asset for the purposes of HKFRS 16. Under HKFRS 16, a
lease exists.
If, however, Easy Removalists was responsible for employing a driver to drive the truck
from Hong Kong to Shanghai (and return) and the driver determined the details of the
journeys taken, Office Storage does not have the right to operate the truck for the one-week
period. Instead, Easy Removalists has the right to direct the use of the asset over the contract.
In that instance, HKFRS 16 would not apply. The contract does not constitute a lease but is a
supply contract between the customer (Office Storage) and supplier (Easy Removalists).
A contract may contain terms and conditions that protect the supplier’s interest in the
asset, protect its personnel, or ensures the supplier’s compliance with laws or regulations.
HKFRS A supplier’s protective rights typically define the scope of the customer’s right of use but do not,
16.B30 in isolation, prevent the customer from having the right to direct the use of an asset.
9.2.1.3 Period of Use
HKFRS A contract contains a lease only for that portion of the term during which the customer has the
16.B10 right to control the use of an identified asset.
Finally, though the period of use is commonly described in terms of time (e.g. years), it may
HKFRS be described in terms of the amount of use of an identified asset, for example, the right to
16.10 control the use of an identified asset for a specified number of production units.
HKFRS The flowchart in Exhibit 9.6 can assist entities in assessing whether a contract is, or
16.B31 contains, a lease.:
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NO
Is there an identified asset?
YES
Does the customer have the right to obtain NO
substantially all of the economic benefits from use of
the asset throughout the period of use?
YES
Customer Does the customer, the supplier or neither party, have Supplier
the right to direct how and for what purpose the asset
is used throughout he period of use?
Neither; how and for what
purpose the asset will be
used is predetermined
YES Does the customer have the right to operate the asset
throughout the period of use, without the supplier
having the right to change those operating instructions?
NO
Did the customer design the asset in a way that NO
predetermines how and for what purpose the
asset will be used throughout the period of use?
YES
The contract does not
The contract contains a lease
contain a lease
EXHIBIT 9.6 Flowchart to determine the presence of a lease at date of inception
Apply and Analyse 1
Steel Supplies Limited (Steel Supplies) enters into a contract with a ship owner, Sea Vessels
Limited (Sea Vessels), for the exclusive use of two cargo ships, Asia-Pacific Express and
ABC Hong Kong, for 10 years. Steel Supplies determines what cargo will be transported
and whether, when and where the ships will sail throughout the 10 years. However, the
contract specifies Steel Supplies cannot carry hazardous materials as cargo nor can it sail
the ships into dangerous waters.
If either of the cargo ships become unseaworthy at any time throughout the 10 years,
Sea Vessels is obliged to replace the cargo ship with another. The contract also requires
Sea Vessels to operate the cargo ships and is responsible for the safe passage of the cargo
on board the ships.
Determine whether the contract between Sea Vessels and Steel Supplies is a lease.
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Apply and Analyse 1 (continued)
Analysis
Following the previous flowchart to analyse if the contract is, or contains, a lease, the
flowchart below answers the pertinent questions present at the inception of the contract:
Is there an identified asset?
Yes, there are two assets explicitly identified in the contract,
namely Asia-Pacific Express and ABC Hong Kong.
Moreover, Sea Vessels’ right to substitute the ships only
arises when the ships become unseaworthy, which does
not constitute a substantive substitution right.
YES
Does Steel Supplies have the right to obtain substantially all
of the economic benefits from use of the cargo ships
throughout the period of use?
Yes, because Steel Supplies has the exclusive use of the
ships throughout the period of use (i.e. 10 years),
including when they are not being used to transport cargo.
YES
Does Steel Supplies, Sea Vessels, or neither party, have
the right to direct how and for what purpose the cargo ships
are used throughout the period of use?
Steel Supplies has the right to direct how and for what
purpose the ships are used, as the contract enables Steel
Supplies to determine what cargo will be transported and
Steel Supplies whether, when and where the ships will sail throughout the
10 years. The restrictions about where the ships can sail
and the cargo they can transport are examples of protective
rights that protect Sea Vessels’ interest in the ships and its
personnel. They define the scope of Steel Supplies’ right of
use of the ships, but do not prevent Steel Supplies from
having the right to direct the use of the ships. Steel Vessels’
decisions regarding operating the ships do not give it the
right to direct how or for what purpose the ships are used.
The contract between Steel Supplies
and Sea Vessels is a lease
Key Learning Point
A lease is a contractual arrangement between an asset owner (lessor) and an entity that
intends to use the asset (lessee). HKFRS 16 applies if a contract specifies an identifiable
asset and the lessee is granted the control over the use of the asset for a specified period
of use if no other accounting standards apply.
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9.2.2 Separating Components of a Contract
A contract that contains a lease may include many parts, including one or more of the
following:
• A lease component or components (e.g. the lessee has the right to use one or multiple
assets over the contract’s duration);
• A non-lease component or components (e.g. the lessor maintains the asset or assets for
a fee); and
• Other charges that do not transfer a good or service to the lessee (e.g. administrative
fees charged by the lessor to the lessee). Such amounts payable by the lessee are not
considered to be a separate component of the contract; instead, they form part of the
HKFRS total contract consideration allocated to the above separate lease and non-lease
16.B33 components.
HKFRS 16 requires the lessor and the lessee to separately account for each lease and
HKFRS
non-lease component of the contract unless the lessee applies the practical expedient (as
16.12, 16.15 discussed in Section 9.2.2.1). The practical expedient does not extend to the lessor, who must
separately account for each lease and non-lease component.
A contract may provide the lessee with rights to use multiple underlying assets
(e.g. a customer may have the right to use a building and the equipment within it). If that is the
case, the entities must identify whether the lessee is contracting for a number of separate
deliverables (i.e. each right to use an asset relates to a separate deliverable, thereby
constituting separate lease components) or whether the lessee is contracting for one
IFRS deliverable that may involve different assets (i.e. each right to use an asset relates to
16.BC134 one deliverable, meaning collectively they constitute one lease component).
In determining whether each right to use an underlying asset constitutes a separate lease
component, both of the following conditions must be satisfied:
1. The lessee can benefit from use of the underlying asset on its own or together with
other resources that are readily available to the lessee (i.e. goods or services sold or
leased separately by the lessor or other suppliers or that the lessee has obtained from
the lessor or other transactions or events).
HKFRS 2. The underlying asset is neither highly dependent on nor highly interrelated with, the
16.B32 other underlying assets in the contract.
Illustrative Example 4
As part of its business operations, Home Supplies offers delivery of items, such as
furniture and televisions. Home Supplies enters into a five-year contract with Storage
Limited (Storage) for the right to exclusively use a warehouse in Hong Kong as its storage
and distribution centre. As part of the agreement, Home Supplies also has the right
to use the adjoining loading area, which enables the items to be delivered and Home
Supplies’ trucks to be loaded for distribution and parked overnight.
From the perspective of Home Supplies, the contract contains only one lease
component. The warehouse is highly interrelated with the adjoining loading area because
haulage could not gain access to the warehouse without having use of the loading area.
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Depending on circumstances, it is necessary to separate the components of a contract
and to allocate the ‘contract consideration’ accordingly because each component may not
necessarily be accounted for in the same way. As such, by disaggregating a contract into its
components, an entity can isolate the appropriate accounting treatment for each component.
Though ‘consideration’ in a lease contract is not defined in HKFRS 16, it is reasonable to
presume that total contract consideration is equivalent to the ‘transaction price’ of the contract,
as defined by HKFRS 15.
The way in which each separate component is accounted for differs from a lessee’s and
lessor’s perspective.
9.2.2.1 Lessee
Unless it adopts the practical expedient provided in HKFRS 16, the lessee allocates total
consideration payable under the contract (i.e. total contract consideration) between each
separate lease component and an aggregated non-lease component (i.e. each separate non-lease
HKFRS component is aggregated as one). Such allocation is made based on the relative stand-alone price
16.13 for each separate lease component and the aggregated non-lease component.
The relative stand-alone price of a separate lease component or an aggregated non-lease
component is determined based on the price the lessor, or a similar supplier, would charge an
entity for that, or a similar, component. An observable stand-alone selling price is preferred,
HKFRS but if one is not available, stand-alone prices will be estimated, maximising the use of
16.14 observable information.
Before allocating contract consideration, a lessee may make an accounting policy election
(as a practical expedient) to not separate non-lease components from lease components. If
making this election, each lease component and related non-lease component will be
accounted for as a single lease component. This election can be made by class of underlying
asset, meaning that if, within a contract, the lessee leases underlying assets across different
HKFRS classes (e.g. investment property; and property, plant and equipment), the lessee will be able to
16.15 choose whether to make this election for each class of underlying asset.
Making the election not to separate lease and non-lease components simplifies how the
lessee accounts for the contract because separately accounting for the lease and non-lease
components is unnecessary. However, before making such an election, an entity might want to
consider the implications for its financial statements given that it results in the non-lease
components forming part of the lessee’s initially recognised assets and liabilities rather than
potentially being only recognised as expenses as they are incurred. If the lessee does not make
HKFRS the election, the lessee accounts for the contract consideration allocated to the aggregated
16.16 non-lease component in accordance with other applicable standards. As such, lease
components are accounted for in accordance with HKFRS 16 and non-lease components with
relevant other standards.
9.2.2.2 Lessor
Unlike a lessee, a lessor must allocate total contract consideration between each lease and
non-lease component. For example, if a supplier enters into a contract with a customer to
lease an asset to the customer, as well as repair and maintain the asset over the contract’s
duration, the supplier (as the lessor) will account for the lease component in accordance with
HKFRS 16 and will account for the contract consideration allocated to the non-lease component
(i.e. for the services provided to repair and maintain the asset) as revenue in accordance
with HKFRS 15.
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When allocating contract consideration to each component, a lessor shall apply HKFRS 15;
the lessor applies Step 4 ‘Allocating the transaction price to performance obligations’ of the
five-step model of revenue recognition (see Chapter 5). HKFRS 15 requires the transaction
price to be allocated to each performance obligation in the contract which, from the lessor’s
perspective, would treat a performance obligation as equivalent to a separate component
(whether lease or non-lease) of the contract.
Apply and Analyse 2
As part of its expansion plans, Home Supplies has purchased a parcel of land in
Guangzhou to build a five-storey ‘mega’ store. To commence its upcoming construction,
Home Supplies enters into a contract with Construct Today Limited (Construct Today) to
lease an excavator and crane for three years. Construct Today also agrees to maintain the
excavator and the crane throughout the term of the contract. The total consideration in the
contract is HK$2.5 million, comprising an upfront administrative fee charged by Construct
Today of HK$100,000 and three annual instalments of HK$800,000. The annual instalments
include the cost of maintenance services on the excavator and crane. For the purposes of
simplicity, ignore discounting for the time value of money.
Within the local area, several companies lease construction equipment. Accordingly,
Home Supplies can establish that the observable stand-alone prices for the leases of the
excavator and crane are HK$900,000 and HK$1.5 million, respectively. Home Supplies can
also establish observable stand-alone prices for maintenance of the excavator and the
crane of HK$40,000 per annum and HK$50,000 per annum, respectively.
HKFRS Home Supplies does not elect to use the practical expedient of HKFRS 16 and instead
16.15 chooses to account for lease and non-lease components separately.
Advise Home Supplies (the lessee) on the separate components present within the
contract and allocate total contract consideration accordingly.
Analysis
The contract provides Home Supplies with the right to use two assets: the excavator and
the crane. Each right of use constitutes a separate lease component because:
• Home Supplies can benefit from the use of the excavator and the crane on their
own or together with other resources readily available to Home Supplies; and
• The excavator and the crane are neither highly dependent on nor highly
interrelated with each other despite being used for the same purpose (i.e. to
construct a mega store). Home Supplies’ ability to benefit from the use of the crane
is not dependent on, or interrelated with, whether Home Supplies decides to lease,
or not lease, the excavator from Construct Today and vice versa.
As such, the lease between Home Supplies and Construct Today contains:
• Two separate lease components (i.e. the separate rights to use the excavator and
the crane);
• Two separate non-lease components (i.e. the separate maintenance of the
excavator and the crane); and
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Apply and Analyse 2 (continued)
• An up-front administration charge, which, because it did not transfer a good or
service to Home Supplies, is not treated as a separate component of the contract.
Home Supplies has chosen to separate lease and non-lease components when
HKFRS allocating the consideration of the contract. However, HKFRS 16 requires that the two
16.13 non-lease components be aggregated to form a single non-lease component meaning that,
for accounting purposes, the contract contains two lease components and one non-lease
component.
The total contract consideration is HK$2,500,000. The total of the observable
stand-alone prices is HK$2,670,000 (i.e. HK$900,000 + HK$1,500,000 + (HK$40,000 per
annum × 3 years) + (HK$50,000 per annum × 3 years)). Home Supplies will allocate total
contract consideration between the two lease components and the aggregated non-lease
component as follows:
Component Allocation of contract consideration
HK$
Excavator 842,697 (calculated as HK$900,000/HK$2,670,000 * HK$2,500,000)
Crane 1,404,494 (calculated as HK$1,500,000/HK$2,670,000 * HK$2,500,000)
Non-lease 252,809 (calculated as HK$270,000/HK$2,670,000 * HK$2,500,000)
Total 2,500,000
9.2.3 Lease Term
At the inception of a contract, suppliers and customers must assess whether the contract is,
or contains, a lease, as this is when the contractual rights and obligations of both entities first
arise. The inception date of a lease is the earlier of the date of the lease agreement and the
date of commitment by the parties to the principal terms and conditions of the lease.
The inception date, however, is different from the commencement date of a lease (and
either precedes or is the same date as the commencement date) because a lease commences
on the date the lessor makes an underlying asset (i.e. the asset subject to the lease) available
for use by the lessee. For example, at the lease’s inception, the lessor has a contractual
obligation to make an underlying asset available for use to the lessee, with such availability
occurring immediately or on a designated future date. Only when the underlying asset first
becomes available for use by the lessee, however, does the lease commence. Although HKFRS
16 requires many assessments to be made as at inception date, the accounting for leases does
not start until the commencement date.
The lease term begins at the commencement date of the lease and extends to:
• The non-cancellable period of the lease;
• Periods covered by an option to extend the lease but only if the lessee is reasonably
certain to extend under the option; and
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HKFRS
• Periods covered by an option to terminate the lease but only if the lessee is reasonably
16.18 certain not to terminate under the option.
HKFRS
The assessment of whether a lessee is reasonably certain to exercise an option to extend,
16.B37 or not to exercise, an option to terminate is made at the commencement date of the lease.
Because this assessment is necessary to establish the term of the lease, an entity can only
determine the lease term at commencement date.
There may be a delay between when the underlying asset becomes available for use by the
lessee and when the lessee begins using the asset because the lessee may, for example, make
modifications or improvements to the underlying asset before putting it into use. Despite this,
the lease term commences when the lessee is given control over the use of the underlying
HKFRS
asset, even though actual use occurs later. This applies even if the lessee is not required to
16.B36 make lease payments during this period.
The non-cancellable period is the period for which the contract is enforceable (i.e. the
lessee and lessor have enforceable rights and obligations). A lease is no longer enforceable
HKFRS
when the lessee and lessor each has the right to terminate without permission from the other
16.B34 party with no more than an insignificant penalty. As such, if the lease contains a term allowing
either party to terminate the lease without the agreement of the other party and without
penalty after a specified time or on a designated future date, the lease will no longer be
enforceable after that point in time. The non-cancellable period of the lease, therefore, ceases
at this point in time.
The determination of the lease term under HKFRS 16 is expressed from the perspective of
the lessee. As such, if only a lessor has the right to terminate, the period covered by that option
HKFRS to terminate is included in the non-cancellable period given that, from the lessee’s perspective,
16.B35
the lease cannot be cancelled. If only a lessee has the right to terminate, the period covered by
HKFRS
that option to terminate is not part of the non-cancellable period unless the lessee is
16.18(b) reasonably certain not to exercise that option.
In assessing whether a lessee is reasonably certain to exercise an option to extend, or not
to exercise an option to terminate, consideration is given to whether an economic incentive
exists. This assessment is made at the commencement date of the lease and accounts for all
relevant facts and circumstances, including any expected changes in facts and circumstances
from the commencement date until the exercise date of the option. These facts and
HKFRS
circumstances, and their impact on the assessment of whether the option will or will not be
16.B37–40 exercised, might include those listed in Exhibit 9.7.
In summary, a lessor and lessee use the preceding factors at the commencement of the
lease as indicators in concluding with reasonable certainty whether a lessee will choose to
extend or terminate the lease. Following the commencement of the lease, the lessee monitors
the lease for significant events or changes that could alter the lease term.
A lessee is required to reassess whether it probably will exercise an extension option or not
exercise a termination option on the occurrence of a significant event or a significant change in
circumstances that:
• Is within the control of the lessee; and
• Affects whether the lessee is reasonably certain to exercise an option not previously
HKFRS
included in its determination of the lease term or not to exercise an option previously
16.20 included in its determination of the lease term.
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Leases
Facts and circumstances to consider Impact on assessment of whether lessee
is to exercise an option to extend or not
exercise the option to terminate
Contractual terms and conditions for the optional If the contractual terms and conditions are
periods compared with market rates. favourable compared to market rates (e.g. lease
payments during the optional period discounted
below market prices or the price at which a
purchase option is exercisable is below current
market prices), the more likely a lessee is to
exercise an option to extend or not exercise the
option to terminate.
Significant leasehold improvements undertaken, If undertaken, or expected to be undertaken, the
or expected to be undertaken and expected to more likely a lessee is to exercise an option to
have significant economic benefit for the lessee extend or not exercise the option to terminate.
over the terms of the contract.
The costliness of terminating the lease to the The more costly it is to terminate, the more likely a
lessee, including negotiation costs, relocation lessee will not exercise the option to terminate.
costs, termination penalties, and the costs in
identifying, and then of integrating, a new asset
into the lessee’s operations.
The importance of the underlying asset to the The greater the importance of the underlying
lessee’s operations. asset to the lessee’s operations, the more likely
a lessee is to exercise an option to extend or not
exercise the option to terminate.
The conditions that must exist for the option If conditions must exist before the option can be
to be exercised and the likelihood of those exercised and they will likely occur, then the lessee
conditions existing. will more likely exercise that option whether
it be to extend or terminate. If, however, the
occurrence of the conditions is unlikely, then the
lessee will less likely exercise the option.
The option to extend or terminate when combined In this case, the lessee is reasonably certain to
with other contractual features (e.g. a residual exercise the option to extend the lease or not to
value guarantee, which is a guarantee made by exercise the option to terminate the lease.
the lessee to the lessor for any difference between
the underlying asset’s residual value and a lower
scrap value realised by the lessor at the end of
the lease term) means that the lessee guarantees
the lessor a minimum or fixed cash return that is
substantially the same regardless of whether the
option is exercised.
The length of non-cancellable period. The shorter the non-cancellable period, the more
likely a lessee is to exercise an option to extend or
not exercise the option to terminate.
The lessee’s past practice regarding the period If the non-cancellable period is similar to the
over which it has typically used similar assets period over which a lessee has typically used
(whether owned or leased). similar assets, then the lessee will less likely
exercise an option to extend. If, however, the
non-cancellable period is shorter than the period
over which a lessee has typically used similar
assets, then the lessee will more likely extend
the lease.
EXHIBIT 9.7 Facts and circumstances to consider when assessing whether it is reasonably certain
a lessee will exercise an option to extend, or not exercise an option to terminate, a lease
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FINANCIAL REPORTING
Examples of significant events or changes in circumstances within the control of the
lessee include:
• Leasehold improvements not anticipated at the commencement date that are
expected to have significant economic benefit for the lessee when the option becomes
exercisable;
• Modification or customisation of the underlying asset not anticipated at the
commencement date;
• The inception of a sublease of the underlying asset for a period beyond the end of the
previously determined lease term; and
• A business decision of the lessee that is directly relevant to exercising, or not exercising,
HKFRS
the option (e.g. a decision to dispose of a business unit within which the underlying
16.B41 asset is used).
If, on the occurrence of a significant event or change in circumstances within the control of
the lessee, the assessment of reasonable certainty changes and the lease term will lengthen or
shorten accordingly.
Illustrative Example 5
Thought Leaders Limited (Thought Leaders) enters into a lease for office space that
includes a six-year non-cancellable period and an option to extend the lease for three
years. The office space is one of many that Thought Leaders leases from various lessors.
History shows that Thought Leaders tends to occupy offices for five years after which it
moves to alternative premises.
Two years after the lease commences, Thought Leaders decides to undertake
improvements to the office space at its own expense. The leasehold improvements are
expected to provide significant benefits to Thought Leaders over many years but can only
be obtained through continued tenancy of the leased office space.
At the time of commencing the lease, the lease term is six years. This is the non-
cancellable period of the lease, with the option to extend the lease for three years not
being part of the lease term. It cannot be concluded with reasonable certainty that
the lessee will exercise the option to extend the lease, accounting for all relevant facts
and circumstances. Such facts and circumstances include that the office space is not
of significant importance to Thought Leaders’ operations, as it is one of many leased
premises, and Thought Leaders’ past practice is typically to occupy office spaces for a
period of time (i.e. five years) that would not require the lease to be extended.
Following the leasehold improvements, Thought Leaders must reassess whether
it will probably not exercise the extension option. The decision to undertake leasehold
improvements is a significant event within Thought Leaders’ control. Given the leasehold
improvements bring significant economic benefits to Thought Leaders over many years,
including the time when the option is exercisable, Thought Leaders will probably now
exercise the extension option. As such, the lease term becomes nine years, with seven
years remaining.
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Leases
9.2.3.1 Determining the Length of the Lease Term for Hong Kong Land Leases
In Hong Kong, land is owned by the Hong Kong Special Administrative Region (HKSAR)
Government that then lease it to others, generally for an extended period of time (e.g. 50 years)
for use. The length of a Hong Kong land lease is to be determined by reference to the legal
form and status of the lease. The lessee can only assume a land lease will be renewed when the
HKFRS lessee has an option to renew and at the inception of the lease the lessee will probably exercise
16.18 the option. As the HKSAR Government has the sole discretion to renew the lease, the lessee
cannot assume the lease term will be extended, even if the HKSAR Government expresses a
general intention to renew the lease prior to renewal. Expressing a general intention to renew
HKFRS
does not create sufficient certainty that renewal will occur. As such, the lessee cannot include
16.BC 127 such intended extensions in the determination of the lease term.
Knowledge Check Questions
Question 2
Oil and Gas Distributors Limited (Oil and Gas) enters into an eight-year contract with Netra
Limited (Netra) for the right to use Netra’s pipeline to transport oil from Hong Kong to
Tokyo. The contract provides Oil and Gas with the right to use a specified amount of the
pipeline’s capacity for the contract’s duration. Explain whether there is an identified asset.
Question 3
An airline company enters into a three-year contract with an aircraft owner for the use of
a specific aircraft for a return flight between Hong Kong and Hawaii that operates every
Monday, Wednesday and Saturday. The airline owner uses the aircraft for the remaining
days. The airline owner is unable to substitute the aircraft for another over the three-year
period unless it needs repair.
Explain whether the airline company has the right to control the use of an
identified asset.
Question 4
Label Limited (Label), the lessee, enters into a five-year contract with TechSpace Limited
(TechSpace), the lessor, for the lease of a retail store. The contract is signed on 1 July
20X7, and provides Label with the right to occupy the premises from 1 August 20X7. Label
then undertakes minor modifications to the retail space, which has its grand opening on
1 September 20X7. Label has the unconditional option to terminate the lease after two
years, without penalty. Lease payments are HK$1,000,000 per annum, which is based
on the current market price per square metre of retail space in the local area, plus 25%
compounding each year of the lease.
Identify which one of the following is the correct lease term.
A 1 August 20X7 – 31 July 20X9
B 1 September 20X7 – 31 August 20X9
C 1 July 20X7 – 30 June 20Y2
D 1 August 20X7 – 31 July 20Y2
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FINANCIAL REPORTING
9 . 3 LESSEE
HKFRS 16 broadly requires lessees to apply a single lease accounting model to all lease
agreements and to recognise assets and liabilities for the rights and obligations created
by a lease. By requiring lessees to recognise the rights and obligations created by all lease
agreements (with only limited exemptions), their financial statements provide a more faithful
representation of the lessee’s total assets and total liabilities.
This section will explore how a lessee is to account for a lease in accordance with HKFRS 16.
9.3.1 Recognition
HKFRS 16 requires a lessee to recognise a right-of-use asset and a lease liability for all leases,
other than for those to which a recognition exemption applies.
The right-of-use asset reflects the lessee’s right to use the underlying asset for the lease
term. The right-of-use asset is distinct from the underlying asset: The lessee does not recognise
the underlying asset in its statement of financial position but rather recognises an asset for
its right to use the underlying asset. For example, Home Supplies would not recognise the
excavator as an asset given ownership of the underlying asset remains with Construct Today,
but it would recognise the right to use the excavator over the lease term as an asset. The subtle
distinction here is that Home Supplies would recognise a ‘lease’ asset and not the ‘leased’ asset.
The lease liability represents the lessee’s obligation to make lease payments to the lessor
over the lease term.
HKFRS The right-of-use asset and lease liability are initially recognised at the commencement date
16.22 of the lease, which is when the underlying asset becomes available for use by the lessee
because it is not until this point in time that the lessee controls the right to use the underlying
asset and has a present obligation to make payments in return for using the underlying asset.
9.3.2 Recognition Exemptions
In general, a lessee is required to recognise a right-of-use asset and a lease liability for all
leases. There are, however, exemptions to this requirement. A lessee can elect not to recognise
HKFRS a right-of-use asset and lease liability for short-term leases and for leases for which the
16.5 underlying asset is of low value.
9.3.2.1 Short-term Leases
HKFRS A short-term lease is a lease that, at the commencement date, has a lease term of 12 months or
16.App A less and does not contain an option to purchase the underlying asset. The election not to
recognise a right-of-use asset and lease liability for short-term leases is made by a class of
HKFRS underlying asset to which the right of use relates. A class of underlying asset is a grouping of
16.8 underlying assets of a similar nature and use in the lessee’s operations.
When determining whether a lease is short-term, a lessee applies the definition of lease
term. The lessee considers:
• The non-cancellable period of the lease;
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• Periods covered by an option to extend but only if the lessee is reasonably certain to
extend; and
• Periods covered by an option to terminate but only if the lessee is reasonably certain
not to terminate.
Illustrative Example 6
Optimal Printing Limited (Optimal Printing) offers photocopier installation and repairs
for universities located in Hong Kong. Optimal Printing enters into an agreement
with FleetFast Limited (FleetFast) to lease a fleet of five motor vehicles. The vehicles
will be used by technicians to visit the universities requesting installation or repair of
photocopiers. The lease has a 10-month non-cancellable period, with Optimal Printing
having the option to extend the lease for six more months. At the commencement of the
lease, Optimal Printing assesses it may not exercise the option to extend the lease.
The lease term is 10 months, being the non-cancellable period of the agreement. As
Optimal Printing is not reasonably certain it will extend the lease, the extension period
is not considered part of the lease term. As the lease term is 12 months or less, Optimal
Printing can elect to account for the lease as a short-term lease. This election is required
to be applied to all motor vehicles leased under the agreement, as the vehicles are of a
similar nature and use in Optimal Printing’s operations.
If a lessee elects not to recognise a right-of-use asset and a lease liability for a short-term
lease, it will recognise the lease payments associated with the lease as an expense on either a
straight-line basis over the lease term or with another systematic basis if it is more
HKFRS representative of the pattern of the benefit derived by the lessee from using the underlying
16.6 asset. For example, if the benefits derived by the lessee from using the underlying asset
systematically decline over time, the lessee will recognise lease payments as an expense using
a diminishing balance basis.
9.3.2.2 Leases for Which the Underlying Asset Is of Low Value
The exemption for low-value leases is restricted. The lessee’s assessment of whether an
underlying asset is of low value is based on the value of the asset when it is new regardless of the
HKFRS age of the asset being leased. For example, an assessment of the value of a leased second-hand
16.B3 car is not based on the current value of the car but rather its value when it was new.
Furthermore, an underlying asset can only meet the criteria for being of low value if:
• The lessee can benefit from use of the underlying asset either on its own or together
with other resources that are readily available to the lessee; and
• The underlying asset is neither highly dependent on, nor highly interrelated with, other
HKFRS assets. No requirement exists that these other assets must be non-low-value assets to
16.B5 prevent the underlying asset itself being low value.
These conditions are consistent with identifying the lease components of a contract (see
Section 9.2.2). As such, if a contract has multiple lease components, the lessee will assess if
each lease component relates to a low-value underlying asset.
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FINANCIAL REPORTING
The assessment of whether an underlying asset is of low value is performed on an absolute
basis regardless of whether the lease is material to the lessee. HKFRS 16 expects different
lessees to reach the same conclusion about whether a particular asset is low value or not
HKFRS
because each lessee’s assessment should be independent of the lessee’s size, nature or
16.B4 circumstances.
Though HKFRS 16 does not attach a monetary threshold to ‘low value’ at the time of
reaching a decision about this recognition exemption, in 2015 (at the time the standard was
IFRS
written), the International Accounting Standards Board (IASB) had in mind leases with a value,
16.BC100 when new, of US$5,000 or less. In today’s terms, this approximately equates to HK$40,000 or
HKFRS
less. HKFRS 16 identifies examples of typical low-value underlying assets as including tablet and
16.B8 personal computers, small items of office furniture and telephones.
HKFRS
The election not to recognise a right-of-use asset and lease liability for a low-value underlying
16.8 asset is made on a lease-by-lease basis. If a lease has more than one low-value underlying asset,
such as when there are more than one separate lease components containing a low-value
underlying asset, the election is required to be applied to all low-value underlying assets covered
by that lease.
As with short-term leases, if a lessee elects to apply this recognition exemption, it will
HKFRS
recognise the lease payments as an expense on a straight-line basis over the lease term or with
16.6 another systematic basis.
Apply and Analyse 3
As part of its expansion plans, Home Supplies has introduced online shopping. The online
shopping store is operated out of a designated office space within one of its warehouses.
Home Supplies enters into a contract with Tech Savvy Limited (Tech Savvy) to lease three
new personal computers (hardware only) accessed by staff to receive online orders and to
answer any online queries. The lease has a two-year non-cancellable period, at the end of
which Home Supplies has the option to extend for 12 more months. Tech Savvy agrees to
offer technical support to Home Supplies throughout the term of the contract.
Home Supplies pays HK$500 per month for the use of each personal computer (i.e.
HK$1,500 per month in total). Of this amount, HK$100 per personal computer per month
relates to the technical support services offered by Tech Savvy. Home Supplies does not
HKFRS elect to use the practical expedient of HKFRS 16, instead choosing to account for lease and
16.15 non-lease components separately.
At the commencement of the lease, the personal computers had a value of HK$10,000
each. Thought the computers are linked to a network server, each computer can be
operated by a user independently of the other computers.
Determine whether Home Supplies is required to recognise a right-of-use asset and
lease liability in relation to the personal computers. If not, explain how Home Supplies
would account for the lease payments to Tech Savvy.
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Leases
Apply and Analyse 3 (continued)
Analysis
The lease agreement between Home Supplies and Tech Savvy is not a short-term lease,
given the non-cancellable period is two years. As such, for Home Supplies to be able to
elect not to recognise a right-of-use asset and lease liability, the lease would need to relate
to a low-value underlying asset.
In making this assessment, Home Supplies considers each personal computer
individually because:
• Home Supplies can benefit from use of one personal computer on its own or
together with other resources that are readily available to Home Supplies; and
• Each personal computer is neither highly dependent on, nor highly interrelated
with, the other assets given each computer can be operated by a user
independently of the others.
Each personal computer is an underlying asset (and a separate lease component).
Home Supplies would view each personal computer as low value, corresponding with
the examples listed in HKFRS 16. Based on this, Home Supplies can elect to apply the
recognition exemption on low-value underlying assets.
The lease agreement contains a non-lease component relating to the technical support
services provided by Tech Savvy. Because Home Supplies chooses to account for lease and
non-lease components separately, payments to Tech Savvy for technical support are not
part of Home Supplies’ lease payments. Monthly lease payments are, therefore, HK$1,200
(i.e. HK$1,500 − HK$300).
Management of Home Supplies considered the costs of applying the recognition
requirements of HKFRS 16 and concluded they would outweigh the financial reporting
benefits and, as such, elects to apply the recognition exemption, meaning the lease
payments are to be expensed. This election is required to be applied to all three low-value
underlying assets within the lease agreement. Presuming Home Supplies’ pattern of benefit
from using each personal computer is constant over the lease term, the lease payments
would be expensed on a straight-line basis.
The monthly journal entry would be:
Debit Credit
HK$ HK$
Lease expense 1,200
Technical support expense 300
Cash 1,500
Key Learning Point
Lessees account for a lease arrangement by recognising one or more right-of-use assets
and a lease liability other than for short-term leases (i.e. 12 months or less) or leases for
which the underlying asset is of low value.
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FINANCIAL REPORTING
9.3.3 Measurement
If a recognition exemption does not apply, or is not adopted, a lessee is required to recognise
a right-of-use asset and lease liability in its financial statements. HKFRS 16 provides guidance
to the lessee on how to measure the right-of-use asset and lease liability, both initially and
subsequently throughout the lease term, which will be the focus of this section.
9.3.3.1 Initial Measurement
The right-of-use asset and lease liability are initially recognised as an asset and liability,
respectively, of the lessee at the commencement date of the lease. We will begin by considering
the initial measurement of the lease liability because it is used as an input to the determination
of the measurement of the right-of-use asset.
Initial Measurement of the Lease Liability
HKFRS
16.26 The lessee measures the lease liability at the present value of future lease payments. Any lease
payments made on the commencement date of the lease are not included in the initial
measurement of the lease liability because they are not in the future and, therefore, are not a
liability because they have been paid. Rather, payments on commencement date are included
in the initial measurement of the right-of-use asset at cost, as described (i.e. DR Right-of-use
asset; CR Cash). Those lease payments included in the initial measurement of the lease liability
comprise the following:
• Fixed payments (including in-substance fixed payments) less any lease incentives
receivable;
• Variable payments that depend on an index or rate;
• Amounts expected to be payable by the lessee under residual value guarantees;
• The exercise price of a purchase option but only if it is reasonably certain to be
exercised by the lessee; and
HKFRS • Penalties to terminate the lease but only if the lease term reflects the lessee exercising
16.27 the option to terminate.
Regular or ongoing lease payments made by the lessee to the lessor for the right to use the
underlying asset may comprise a fixed and variable portion:
• The fixed portion (less any lease incentives receivable) is included in the measurement
of a lease liability. Lease incentives relate to enticements provided by the lessor to the
lessee to sign the lease agreement and might include upfront cash payments, the
reimbursement of costs of the lessee (e.g. moving expenses) or the assumption by the
HKFRS lessor of costs otherwise borne by the lessee (e.g. termination penalties on an existing
16.App A lease with another lessor).
• The variable portion will be included only if it varies because it is linked to an index or
HKFRS
16.28 rate, such as a consumer price index (CPI), benchmark interest rate (e.g. LIBOR), or
HKFRS market rental rates. Such variable lease payments are initially measured based on the
16.27 index or rate at the commencement date.
If the variable portion is linked to other factors, such as lessee performance or extent
of usage of the underlying asset, it does not form part of the measurement of the lease
liability. For example, if a lease agreement specifies annual lease payments of HK$600,000
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Leases
plus 0.5% of lessee sales from the previous year, only the fixed annual portion of HK$600,000
will be included in measuring the lease liability. This is because the lessee has some degree
of influence over its sales performance or asset usage, thereby enabling it to potentially
manipulate the measurement of its lease liability through its performance. Excluding a variable
portion linked to performance or asset usage limits the ability of the lessee to manipulate its
lease liability, while an index or rate is independently determined beyond the influence of
the lessee.
Distinct from variable lease payments dependent on an index or rate are those payments
that contain variability but, in substance, are unavoidable. These lease payments are classified
as in-substance fixed payments and arise in the following examples:
• Payments are structured as variable lease payments, but there is no genuine variability
in the payments because they contain variable clauses that do not have real economic
substance. These types of payments include:
°° Payments that must be made only if an asset is proven to be capable of operating
during the lease or only if an event occurs that has no genuine possibility of not
occurring; or
°° Payments are initially structured as variable lease payments for which the variability
will be resolved at some point after the commencement date so the payments
become fixed for the remainder of the lease term. These payments become
in-substance fixed payments when the variability is resolved;
• The lessee could make more than one set of payments, but only one set of payments is
realistic. In this case, the lessee and lessor must consider the realistic set of payments
to be the lease payments; and
• The lessee could make more than one realistic set of payments, but it must make at
least one of those sets of payments. In this case, the lessee and lessor must consider
HKFRS
the set of payments that aggregates to the lowest present value amount to be the lease
16.B42 payments.
A residual value guarantee is a guarantee made to a lessor by a party unrelated to the
HKFRS
lessor so that the value (or part thereof) of an underlying asset at the end of a lease will be at
16.App A least a specified amount. This lessee makes this guarantee. Only if the guarantee is made by
the lessee is it included in the initial measurement of the lease liability.
Lease payments included in the measurement of the lease liability must be discounted to
present value amounts. The discount rate to use is the interest rate implicit in the lease if it can
be determined. Determining the interest rate implicit in the lease is considered in
Section 9.4.2.1. The interest rate implicit in the lease may be affected by factors only known to
the lessor, such as any initial direct costs of the lessor and the lessor’s estimate of the residual
IFRS 16,
para value of the underlying asset at the end of the lease term. As such, lessees will have difficulty
BC161 determining the interest rate implicit in a lease. If the interest rate implicit in the lease cannot
be determined by the lessee, the discount rate to use is the ‘lessee’s incremental borrowing
rate’, which is the rate of interest a lessee would be charged to borrow funds over a similar
HKFRS
term (i.e. the lease term) and with similar security (i.e. collateral), to obtain an asset of similar
16.App A value to the right-of-use asset in a similar economic environment.
Lease payments do not include payments allocated to non-lease components of a contract.
If, however, the lessee makes an election (as a practical expedient of HKFRS 16) not to separate
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FINANCIAL REPORTING
HKFRS
non-lease components from lease components, payments that will otherwise be allocated to
16.15 the non-lease components will be included as lease payments.
Initial Measurement of the Right-of-use Asset
At the commencement date of the lease, the lessee measures the right-of-use asset at cost,
which comprises the following:
• The amount of the initial measurement of the lease liability, as explained;
• Any lease payments at or before the commencement date, less any lease
incentives received;
• Any initial direct costs incurred by the lessee; and
• The estimated costs in dismantling and removing the underlying asset, restoring the
HKFRS
site on which it is located or restoring the underlying asset to the condition required by
16.23–24 the terms of the lease.
HKFRS
Initial direct costs are the incremental costs of obtaining a lease that would not have
16.App A otherwise been incurred and might have included commissions and legal fees payable.
A lessee may incur the obligation for dismantling, removal and restoration costs either at
the lease’s commencement date or because of having used the underlying asset during the
lease term. The costs are to be included in the cost of the right-of-use asset when the obligation
first arises. As such, if a lessee incurs an obligation for dismantling, removal and restoration
costs subsequent to the lease’s commencement date, they are not included in the initial
measurement of the right-of-use asset but rather are included in the subsequent measurement
of the right-of-use asset. The obligation to incur these costs is recognised and measured in
accordance with HKAS 37 Provisions, Contingent Liabilities and Contingent Assets.
Apply and Analyse 4
Management of Home Supplies decides to open a new retail store at a local shopping
centre in Kowloon. It enters into a contract with Luxury Limited (Luxury) to lease a specific
retail store, located at the main entrance of the shopping mall, for a six-year period. Home
Supplies has the option to terminate the lease after four years at a penalty of HK$150,000.
Home Supplies is unsure it will exercise the option to terminate the lease. Under the terms
of the agreement, Home Supplies makes all decisions about the use of the retail store
during the period of use, including the products sold, their sale price, and the quantity of
inventory held.
The lease is entered into on 1 January 20X9. Before signing the agreement, Home
Supplies hired local solicitors to review the terms of the agreement, who charged
HK$20,000 for their services.
The retail store is currently vacant and is available for immediate use. Home Supplies
undertakes leasehold improvements totalling HK$250,000 to outfit the store to be
consistent with the layout of its other retail stores. At the commencement of the lease,
Home Supplies has an obligation to dismantle the leasehold improvements at the end
of the lease term, which it estimates will cost HK$50,000 in today’s dollars. As part of
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Leases
Apply and Analyse 4 (continued)
the contract, Luxury is to provide cleaning and security services at an additional cost to
Home Supplies.
Annual payments are in advance, commencing on 1 January 20X9 (being the
commencement date of the lease) with a payment of HK$300,000. As part of this payment,
HK$75,000 relates to fees charged by Luxury for cleaning and security services for the
upcoming year. Each subsequent annual payment equals HK$300,000 plus the change in
the consumer price index (CPI) for the previous 12 months. The CPI as of 31 December
20X8 is 100. Fees charged by Luxury for cleaning and security are fixed at HK$75,000
per annum. The interest rate implicit in the lease is 4% per annum. No residual value is
guaranteed by Home Supplies at the end of the lease term.
The lease agreement stipulates that ownership of the retail store will be retained by
Luxury at the end of the lease term. The useful life of the retail store is estimated to be
25 years. Home Supplies expects to consume the economic benefits from the retail store
evenly over the lease term.
For ease of computation and to reduce complexity in the application of HKFRS 16,
HKFRS Home Supplies elects the practical expedient HKFRS 16 by choosing to account for any
16.15 lease and non-lease components as a single lease component.
Calculate the initial measurement of the lease liability and right-of-use asset of Home
Supplies. Prepare the journal entry to record the initial recognition and measurement by
Home Supplies.
Analysis
Before measuring the right-of-use asset and lease liability, the characteristics of the
contract need to be established on the inception date. A lease exists because Home
Supplies has a right to control the use of an identified asset (i.e. a specific retail store within
the shopping mall) over a period of time. That is, Home Supplies derives substantially
all of the economic benefits from the use of the store during that period because it has
exclusive use of the store and can direct the use of the retail store, including decisions
on the products sold, their sale price and the quantity of inventory held. The agreement
contains a lease (i.e. the use of the retail store) and a non-lease (i.e. the cleaning and
security services provided by Luxury) component, but Home Supplies elects to account for
these as a single lease component. The lease term is six years, because Home Supplies is
reasonably certain it will not exercise its option to terminate the lease.
The initial measurement of the lease liability equals the present value of future lease
payments. The first annual payment of HK$300,000 is not included in this measurement
because it is not a ‘future’ lease payment. The fixed portion of the future annual payments
relates to the lease and non-lease components. However, because Home Supplies elects
not to separate the two, the entire HK$300,000 per annum is treated as a lease payment.
The variable portion of the future annual payments is also a lease payment because it
varies based on the CPI, with all future variable lease payments initially measured using
CPI prevailing at commencement date (i.e. 100). Because the lease term does not reflect
Home Supplies’ option to terminate, the termination penalties are excluded from the initial
measurement of the lease liability.
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FINANCIAL REPORTING
Apply and Analyse 4 (continued)
Based on an implicit interest rate of 4% per annum, the initial measurement of the
lease liability is HK$1,335,547, calculated as follows:
Payment Discount rate Present value
HK$ HK$
1 January 20Y0 300,000 1/1.04 288,462
1 January 20Y1 300,000 1/1.04 2
277,367
1 January 20Y2 300,000 1/1.043 266,699
1 January 20Y3 300,000 1/1.044 256,441
1 January 20Y4 300,000 1/1.045 246,578
Lease Liability 1,335,547
Initial measurement of the right-of-use asset includes the lease liability, as calculated
above, and the lease payment made on commencement of the lease. Initial direct costs
include the legal fees of HK$20,000 because the fees are an incremental cost incurred as
a consequence of obtaining the lease. Finally, the estimated dismantling costs are also
included, as Home Supplies incurs this obligation on commencement of the lease. In sum,
the initial measurement of the right-of-use asset in accordance with HKFRS 16 comprises
the following:
Cost item Amount
HK$
Lease liability 1,335,547
Lease payment at commencement date 300,000
Initial direct costs 20,000
Estimated dismantling costs 50,000
Right-of-use asset 1,705,547
The journal entry on 1 January 20X9 (being commencement date) to record the initial
measurement of the lease liability and the right-of-use asset is as follows:
Debit Credit
HK$ HK$
Right-of-use asset 1,705,547
Lease liability 1,335,547
Cash 300,000
Legal fees payable 20,000
Provision for dismantling costs 50,000
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Leases
9.3.3.2 Subsequent Measurement
Following the commencement date of the lease, the lessee continues to recognise a right-of-
use asset and a lease liability at their carrying amounts over the term of the lease. The lessee
needs to account for accumulated depreciation and any accumulated impairment losses when
subsequently measuring the right-of-use asset; the carrying amount of the lease liability will
change over the duration of the lease due to interest accretion (often referred to in practice
as the unwinding of the discount) and lease payments made by the lessee. The subsequent
measurement of the right-of-use asset and the lease liability will also reflect adjustments due to
changes to the terms of the lease and certain lease modifications.
Subsequent Measurement of the Lease Liability
Following the commencement date of the lease, when measuring a lease liability, a lessee is
required to:
• Increase the carrying amount to reflect interest on the lease liability;
• Reduce the carrying amount to reflect lease payments made; and
HKFRS • Remeasure the carrying amount to reflect any reassessment or lease modifications or
16.36 to reflect revised in-substance fixed lease payments.
By increasing the carrying amount of a lease liability each period by interest expense,
HKFRS 16 uses what is referred to as an ‘effective interest method’ to subsequently measure
lease liabilities. By adopting an effective interest method, lease liabilities are measured on an
IFRS amortised cost basis. An amortised cost basis is the basis used to measure certain financial
16.BC182 liabilities under HKFRS 9 (see Chapter 12).
In calculating interest expense, the interest rate implicit in the lease is used if it can be
determined; otherwise, the lessee’s incremental borrowing rate is used. The rate adopted is
used to discount lease payments to present value terms and, as such, is referred to as the
discount rate.
If a reassessment of the lease liability due to a change in the lease term or a change in the
HKFRS
16.40, assessment of exercising a purchase option occurs or a lease modification that is not accounted
45(c) for as a separate lease occurs, a revised discount rate will be used to calculate interest expense.
Reassessment of the lease liability and lease modifications is discussed further in
Section 9.3.3.2.
Subsequent Measurement of the Right-of-use Asset
Following the commencement date of the lease, a right-of-use asset is measured at cost less
HKFRS any accumulated depreciation and any accumulated impairment losses and adjusted for any
16.30 remeasurement of the lease liability.
A lessee depreciates a right-of-use asset in accordance with HKAS 16 Property, Plant and
Equipment, meaning the depreciation method chosen should reflect the pattern in which the
future economic benefits of the right-of-use asset are expected to be consumed by the lessee.
If the lease transfers ownership to the lessee at the end of the lease term or it is reasonably
certain the lessee will exercise an option to purchase the underlying asset, the right-of-use
asset will be depreciated from the lease’s commencement date to the end of the underlying
HKFRS asset’s useful life. Otherwise, the depreciation period is from the commencement date to the
16.32 earlier of the end of the useful life of the right-of-use asset or the end of the lease term.
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FINANCIAL REPORTING
HKFRS
HKAS 36 Impairment of Assets applies to determine whether a right-of-use asset is impaired
16.33 and how to account for any impairment loss. Refer to Chapter 14 to gain an understanding of
the impairment of assets.
Even though a lessee continues to measure right-of-use assets at cost (i.e. the cost model),
two exceptions exists:
1. If right-of-use assets relate to a class of property, plant and equipment to which the
lessee applies the revaluation model in HKAS 16, a lessee may elect to apply that
revaluation model to all the right-of-use assets related to that class of property, plant
and equipment (see Chapter 7); and
2. If the lessee applies the fair value model in HKAS 40 Investment Property to its
HKFRS
investment property, the lessee shall also measure right-of-use assets that meet the
16.34–35 HKAS 40 definition of investment property at fair value (see Chapter 8).
Though the first exception permits lessees to choose between the cost model and the
revaluation model in measuring right-of-use assets when the related property, plant and
equipment is measured using the revaluation model, under the second exception, the lessee
must adopt the fair value model to its right-of-use assets.
Reassessment of the Lease Liability and Modifications
After a lease commences, changes may occur that affect the future lease payments to be paid
by the lessee. These include changes in:
• The lease term (e.g. a change in the assessment of whether a lessee is reasonably
certain it will exercise an extension option or not exercise a termination option);
• Whether the lessee is reasonably certain about exercising a purchase option;
• Amounts to be paid under a residual value guarantee; or
• Variable lease payments due to a change in an index or rate used to determine those
HKFRS
payments, including the market-wide replacement of an interest rate benchmark on
16.40, 42 which lease payments are based with an alternative benchmark interest rate.
If any of the above changes occur, the lessee is required to remeasure the lease liability. On
remeasurement, the increase or decrease to the lease liability is recognised with a
corresponding adjustment to the right-of-use asset. If, however, the carrying amount of the
HKFRS
right-of-use asset is reduced to zero and a further reduction in the measurement of the lease
16.30(b), 39 liability occurs, any remaining amount is recognised by the lessee in profit or loss.
Type of change Discount rate to use
Lease term Discount revised estimated lease payments
arising from that type of change using revised
Assessment of whether purchase option will
discount rate
be exercised
Amounts to be paid under residual Discount revised estimated lease payments arising
value guarantee from that type of change using original discount
rate (unless the change in variable lease payments
Variable lease payments due to a change in
is due to a change in floating interest rates in
index or rate
which case a revised discount rate is used that
reflects the floating rate change)
EXHIBIT 9.8 Which discount rate to use on the remeasurement of a lease liability?
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Leases
As summarised in Exhibit 9.8, the discount rate to be used to remeasure the lease liability
depends on the type of change that occurs. If the lease term changes or the assessment about the
lessee exercising a purchase option changes, a revised discount rate will be used because the
IFRS
economics of the lease have changed and it is appropriate to reassess the discount rate to be
16.BC194 consistent with the change in lease payments arising from these two types of changes. The revised
discount rate is the interest rate implicit in the lease for the remainder of the lease term if it can be
HKFRS
readily determined; otherwise, it is the lessee’s incremental borrowing rate at the date of
16.41 reassessment. For the remaining changes (being the last two preceding dot points), the lease
liability is remeasured using the original discount rate unless the change in lease payments results
HKFRS
from a change in floating interest rates in which case the lessee shall use a revised discount rate
16.43 that reflects changes in the interest rate. A revised discount rate is used when lease payments
IFRS
change resulting from changes in the floating rate to be consistent with the measurement of
16.BC195 floating-rate financial liabilities subsequently measured at amortised cost under HKFRS 9.
Refer to Chapter 12 to gain an understanding of the measurement of financial liabilities.
Illustrative Example 7
Lessee Limited (Lessee) enters into a three-year lease agreement with Lessor Limited
(Lessor) on 1 January 20X2. Under the terms of the lease agreement, annual payments
of HK$100,000 are payable in arrears, with the first payment due on 31 December 20X2.
Lessee has the option to extend the lease by two years (at no penalty) at any time during
the three-year period. On 1 January 20X2 (i.e. the commencement date of the lease),
lessee is uncertain it will exercise the option to extend the lease. The interest rate implicit
in the lease is 3% per annum.
Based on an implicit interest rate of 3% per annum, the initial measurement of the
lease liability is HK$282,861, calculated as follows:
Payment Discount rate Present value
HK$ HK$
31 December 20X2 100,000 1/1.03 97,087
31 December 20X3 100,000 1/1.032
94,260
31 December 20X4 100,000 1/1.033 91,514
Lease Liability 282,861
On 31 December 20X2, the lease liability balance is updated due to interest accretion
of HK$8,486 (HK$282,861 × 3%) for the year ended 31 December 20X2 and the payment
of HK$100,000 on 31 December 20X2. After such updates, the lease liability balance is
HK$191,347 (HK$282,861 + HK$8,486 − HK$100,000).
On 1 January 20X3, Lessee decides to extend by two more years, resulting in the
remaining lease term being four years. Annual payments remain at HK$100,000, payable
on 31 December. Due to the change in lease term, the interest rate implicit in the lease is
calculated at 2.5% per annum.
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FINANCIAL REPORTING
Illustrative Example 7 (continued)
Based on an implicit interest rate of 2.5% per annum, the remeasurement of the lease
liability is HK$376,197, calculated as follows:
Payment Discount rate Present value
HK$ HK$
31 December 20X3 100,000 1/1.025 97,561
31 December 20X4 100,000 1/1.0252
95,181
31 December 20X5 100,000 1/1.0253
92,860
31 December 20X6 100,000 1/1.0254 90,595
Lease Liability 376,197
As a result of the change in lease term, the lease liability increases by HK$184,850
(HK$376,197 − HK$191,347). A corresponding increase to the right-of-use asset is also
recognised with the following journal entry on 1 January 20X3:
Debit Credit
HK$ HK$
Right-of-use asset 184,850
Lease liability 184.850
Apply and Analyse 5
Continuing with the analysis of the lease between Home Supplies and Luxury, CPI as of
31 December 20X9 is 102.
Calculate the subsequent measurement of the lease liability and right-of-use asset of
Home Supplies. Prepare the journal entries to record those subsequent measurements by
Home Supplies at the end of the first year of the lease term.
Analysis
On 31 December 20X9, the carrying amount of the lease liability is HK$1,388,969
(HK$1,335,547 plus interest accretion at 4%). The interest rate implicit in the lease remains
at 4% per annum because the remeasurement of the lease liability is necessitated by a
change in variable lease payments due to a change in CPI. As such, the original discount
rate is used. The interest accretion (HK$1,335,547 × 4% = HK$53,422) on the lease liability
in the first year is accounted for with the following journal entry:
Debit Credit
HK$ HK$
Interest expense 53,422
Lease liability 53,422
Due to a change in the CPI over the previous 12 months and in accordance with
the lease agreement, the annual lease payments subsequent to 31 December 20X9 are
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Leases
Apply and Analyse 5 (continued)
adjusted to HK$306,000 (HK$300,000 × (102/100)), and the lease liability is remeasured
as follows:
Payment Discount rate Present value
HK$ HK$
1 January 20Y0 306,000 306,000
1 January 20Y1 306,000 1/1.04 294,231
1 January 20Y2 306,000 1/1.042
282,914
1 January 20Y3 306,000 1/1.043
272,033
1 January 20Y4 306,000 1/1.044 261,570
Lease Liability 1,416,748
Accordingly, Home Supplies increases the lease liability by HK$27,779, which is the
difference between the remeasured lease liability (HK$1,416,748) and its previous carrying
amount (HK$1,388,969). A corresponding adjustment to the right-of-use asset is reflected
in the following journal entry on 31 December 20X9:
Debit Credit
HK$ HK$
Right-of-use asset 27,779
Lease liability 27,779
Home Supplies is also required to depreciate the right-of-use asset for the year ended
31 December 20X9. As ownership does not transfer to Home Supplies at the end of the
lease term, Home Supplies will depreciate over the shorter of the lease term (six years) or
the useful life of the retail store (25 years). As such, depreciation will be over six years.
The depreciation expense for 20X9 is based on the initial measurement of the right-
of-use asset (HK$1,705,547). Following the adjustment to the right-of-use asset arising
from the remeasurement of the lease liability, its carrying amount prior to depreciation
is HK$1,733,326 (i.e. HK$1,705,547 + HK$27,779). There is no guaranteed residual value
and, as Home Supplies expects to consume the economic benefits from the retail store
evenly over the lease term, depreciation is calculated on a straight-line basis. As such,
depreciation expense equals (HK$1,705,547/6 years = HK$284,258) and is represented by
the following journal entry on 31 December 20X9:
Debit Credit
HK$ HK$
Depreciation – Right-of-use asset 284,258
Accumulated depreciation – Right-of-use asset 284,258
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FINANCIAL REPORTING
Apply and Analyse 5 (continued)
There is no indication of impairment of the right-of-use asset.
On 1 January 20Y0, Home Supplies recognises the lease payment as follows:
Debit Credit
HK$ HK$
Lease liability 306,000
Cash 306,000
Following this entry, the carrying amount of the lease liability is HK$1,110,748
(HK$1,416,748 − HK$306,000).
Distinct from the preceding changes, modifications to a lease might occur following the
HKFRS commencement date. A ‘lease modification’ is a change in the scope of a lease, or the
16.App A consideration for a lease, that was not part of the original terms and conditions of the lease.
A change in the scope of a lease could include, for example:
• Adding or terminating the right to use one or more underlying assets; or
HKFRS
16.App A • Extending or shortening the contractual lease term.
Somewhat counter-intuitively, ‘extending or shortening the contractual lease term’
is different from the ‘change in lease term’ previously discussed. A change in lease term
arises due to changes in terms and conditions that existed at commencement date
(e.g. a reassessment of reasonable certainty about exercising an extension or termination
option where that option has always existed in the lease agreement). A change in the scope
of the lease arises when new terms and conditions are added to the lease agreement that
extend or shorten the contractual lease term (e.g. the addition of an option to extend or
terminate the lease to the lease agreement, and the lessee is reasonably certain it will
exercise that option).
On a lease modification occurring, the lessee must determine whether the modification
is to be accounted for as a separate lease or not. A lease modification is accounted for as a
separate lease if:
• The modification increases the scope of the lease by adding the right to use one or
more underlying assets; and
HKFRS • The consideration for the lease increases by an amount commensurate with the
16.44 stand-alone price for the increase in scope.
If both conditions are satisfied, then two separate leases exist: the original ‘unmodified’
lease and the separate lease modification. The lessee accounts for the separate lease
modification applying the recognition and initial and subsequent measurement requirements
detailed in the preceding information.
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Leases
As a result of the COVID-19 pandemic, many lessors are providing lessees with rent
concessions in the form of reduced lease payments for a period of the lease term. Such
rent concessions may constitute lease modifications given they change the consideration
for the lease. However, a practical expedient exists in HKFRS 16 that allows a lessee to
elect not to assess whether a rent concession constitutes a lease modification, and instead
elect to account for the rent concession as a change to the lease per HKFRS 16.39. For a
lessee to be able to apply this practical expedient, all the following conditions must be
satisfied:
• the rent concession occurs as a direct result of the COVID-19 pandemic;
• the revised total lease payments for the lease are substantially the same, or less than,
total lease payments immediately prior to the change;
• the rent concession reduces only lease payments originally due on or before
30 June 2022; and
• there is no substantive change to other terms and conditions of the lease
(HKFRS 16.46A; 46B).
If all the above conditions are not satisfied, or they are all satisfied but the lessee elects
not to apply the practical expedient, the lessee must assess whether the rent concession is a
lease modification. If it is, the lessee must then consider whether it is to be accounted for as a
separate lease.
Illustrative Example 8
On 1 January 20X1, Premium Real Estate Limited (Premium) enters into an eight-year
lease with Space Creators Limited (Space Creators) for 1,000 square metres of office
space. Due to a real estate boom, Premium wishes to expand its business. On 1 January
20X4, Premium and Space Creators amend the lease agreement to include an additional
2,000 square metres of office space located adjacent to the existing office space. Existing
tenants are to depart on 1 July 20X4, after which the office space becomes available to
Premium for the remaining lease term (4.5 years). The increase in total consideration
for the lease is commensurate with current market rates for 2,000 square metres in the
local area.
A lease modification exists because the scope of the lease has changed by adding
the right to use another additional identified asset (i.e. 2,000 square metres of office
space). Premium accounts for the lease modification as a separate lease given that the
modification increases the scope of the lease by adding the right to use the additional
office space, and the consideration payable for the additional office space reflects
current rental rates in the local area. As such, Premium now has two leases: the original
‘unmodified’ lease of 1,000 square metres of office space and the new lease of 2,000
square metres of office space. The commencement date of the new lease is 1 July 20X4,
which is when the additional office space becomes available for use. On 1 July 20X4,
Premium recognises a right-of-use asset and a lease liability relating to the lease of
the 2,000 square metres of office space. The new lease has a lease term of 4.5 years.
The original lease of 1,000 square metres of office space remains unchanged.
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FINANCIAL REPORTING
If a lease modification is not determined to be a separate lease, on the date of the
modification the lessee must:
• Identify the lease and non-lease (if any) components of the modified lease contract and
allocate contract consideration to each (unless the lessee elects the practical expedient
of para 15 of HKFRS 16, in which each lease component and associated non-lease
component are treated as one when allocating contract consideration);
• Determine the lease term of the modified lease; and
• Remeasure the lease liability by discounting the revised lease payments using a revised
HKFRS
discount rate. The revised discount rate is as previously discussed in the beginning of
16.45 this section.
Once the lessee performs these steps, how it accounts for the lease modification
depends on whether the lease modification decreases the scope of the lease (partially or
fully) or not.
A lease modification decreasing the scope of the lease (e.g. reduces the square footage of
leased office space) requires a remeasurement of the lease liability and a separate reduction in
the carrying amount of the right-of-use asset because a portion of the underlying asset is no
longer available for use. If the remeasurement of the lease liability and the reduction in the
HKFRS
carrying amount of the right-of-use asset do not equal, the difference is recognised in profit or
16.46(a) loss on the date of the modification.
For all other lease modifications, the remeasurement of the lease liability is accompanied
by a corresponding adjustment to the right-of-use asset until the right-of-use asset is reduced
HKFRS
to zero,after which any remaining amount of the remeasurement is recognised in
16.46(b) profit or loss.
Illustrative Example 9
On 1 January 20X1, Cheap Real Estate Limited (Cheap) enters into a six-year lease with
Space Creators for 4,000 square metres of office space. Despite the real estate boom,
Cheap is experiencing a reduction in commission revenue. On 1 January 20X4, Cheap
and Space Creators amend the lease agreement to reduce the office space to 2,000
square metres, beginning 1 July 20X4. Revised lease payments are payable in arrears
and are HK$120,000 per annum thereafter. The lease term now ends on 30 June 20X6.
The revised discount rate is 5% per annum. Assume that, on 30 June 20X4, the carrying
amounts of the right-of-use asset and the lease liability are HK$392,752 and HK$402,960,
respectively.
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Leases
Illustrative Example 9 (continued)
A lease modification that decreases the scope of the lease exists. Because it is
unaccounted for as a separate lease, on 1 July 20X4, Cheap will need to determine the
remaining lease term (two years) and remeasure the modified lease liability as follows:
Payment Discount rate Present value
HK$ HK$
30 June 20X5 120,000 1/1.05 114,286
30 June 20X6 120,000 1/1.052
108,844
Lease Liability 223,130
The pre-modification carrying amount of the right-of-use asset and the lease liability
are reduced by 50%, given only half of the office space is now available for use. This
reduces the carrying amount of the right-of-use asset by HK$196,376 (HK$392,752 × 0.50)
and the carrying amount of the lease liability by HK$201,480 (HK$402,960 × 0.50). On 1 July
20X4, Cheap recognises the difference between the decrease in the carrying amounts of
the right-of-use asset and the lease liability as a gain in profit or loss with the following
journal entry:
Debit Credit
HK$ HK$
Lease liability 201,480
Right-of-use asset 196,376
Gain on lease liability remeasurement 5,104
An additional lease modification exists, being the change in consideration payable by
Cheap for the lease. The difference between the carrying amount of the lease liability after
the preceding journal entry (HK$201,480) and the modified lease liability (HK$223,130) is
accounted for as an adjustment to the right-of-use asset:
Debit Credit
HK$ HK$
Right-of-use asset 21,650
Lease liability 21,650
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Key Learning Point
The measurement of a lease liability is the sum of the discounted periodic lease payments,
and the measurement of a right-of-use assets builds upon the value of the lease liability
and adds upfront direct costs as well as any costs of removing at the end of usage
associated with the right-of-use assets.
9.3.4 Presentation
Under HKFRS 16, the presentation requirements for lessees for each financial statement can be
summarised as in Exhibit 9.9.
Financial statement type Presentation
Statement of financial position Right-of-use assets (that are not investment property)
Separately from other assets; or
Within the same line item as the corresponding underlying assets
would be presented if they were owned, with disclosure of which line
items include right-of-use assets.
Right-of-use assets (that are investment property)
Presented as investment property.
Lease liabilities
Separately from other liabilities; or
Together with other liabilities, with disclosure of which line items
include lease liabilities.
Statement of profit or loss and Interest expense on lease liability and depreciation charge on
other comprehensive incomea right-of-use asset presented separately.
Interest expense as a component of finance costs.
Statement of cash flows (see Cash payments for the principal portion of the lease liability
Chapter 27) presented within financing activities.
Cash payments for the interest portion of the lease liability presented
according to how the lessee classifies interest paid in accordance with
HKAS 7 Statement of Cash Flows.
Lease payments for short-term leases and low-value asset leases
(for which the recognition exemption applies) are presented within
operating activities.
HKFRS Variable lease payments that do not depend on an index or rate are
16.47–50 presented within operating activities
a
KFRS 16 does not outline the presentation requirements for lease payments expensed due to the lessee electing to
H
apply the recognition exemptions discussed in Section 9.3.2.
EXHIBIT 9.9 Presentation requirements for lessees under HKFRS 16
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9.3.5 Disclosure
HKFRS HKFRS 16 requires lessee disclosures to be a single note or a separate section in the lessee’s
16.52 financial statements, and to include the following amounts (where applicable):
• Depreciation charge for right-of-use assets by class of underlying asset;
• Interest expense on lease liabilities;
• The expense relating to short-term leases (for which the recognition exemption applies)
with a lease term greater than one month;
• The expense relating to low-value asset leases (for which the recognition
exemption applies);
• The expense relating to variable lease payments that do not depend on an
index or rate;
• Income from subleasing right-of-use assets;
• Total cash outflow for leases;
• Additions to right-of-use assets;
• Gains or losses arising from sale and leaseback transactions, which is discussed in
Section 9.5; and
HKFRS • The carrying amount of right-of-use assets at the end of the reporting period by class of
16.53 underlying asset.
HKFRS The above disclosures are provided in tabular format unless another format is more
16.54 appropriate. In addition, a maturity analysis of lease liabilities is to be disclosed, separately
HKFRS from the maturity analysis of other financial liabilities required under HKFRS 7 Financial
16.58 Instruments: Disclosures. Because the lessee accounting model is based on the premise that a
HKFRS lease liability is a financial liability, lessees should apply the same maturity analysis disclosure
16.BC222 requirements to lease liabilities as those applied to other financial liabilities.
Also, if a lessee applies the practical expedient to account for rent concessions as lease
changes (and not assess whether they constitute lease modifications), the lessee is required
HKFRS to disclose that fact, as well as the amount recognised in profit or loss for the reporting
16.60A period to reflect changes in lease payments that arise from such rent concessions.
Exhibit 9.10 shows a note disclosure of China Starch Holdings Limited (China Starch) from
its 2021 annual report. China Starch is a lessee of property, plant and equipment, is listed on
the Stock Exchange of Hong Kong Limited and prepares its financial statements in accordance
with HKFRSs. Exhibit 9.10 relates to China Starch’s right-of-use assets note disclosure and of
those items previously listed the following amounts (amongst other things) are disclosed:
• Depreciation charge for right-of-use assets by class of underlying asset (i.e. property,
plant and equipment);
• Additions to right-of-use assets;
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FINANCIAL REPORTING
• The carrying amount of right-of-use assets at the end of the reporting period by class of
underlying asset;
• Total cashflow for leases; and
• The expense relating to short-term leases.
Notes to the Consolidated Financial Statements
For the year ended 31 December 2021
18. RIGHT-OF-USE ASSETS
Leased
properties
HK$′000
Carrying amount
At 31 December 2021 19,095
At 31 December 2020 28,388
Depreciation
Provided for the year ended 31 December 2021 9,293
Provided for the year ended 31 December 2020 9,582
2021 2020
HK$′000 HK$′000
Expense relating to short-term leases 8 26
Total cash outflow for leases 9,752 9,664
Addition to right-of-use assets – 27,536
For both years, the Group leases offices for its operations. Lease contracts are entered into for
fixed term of three years. Lease terms are negotiated on an individual basis and contain different
terms and conditions. In determining the lease term and assessing the length of the non-
cancellable period, the Group applies the definition of a contract and determines the period for
which the contract is enforceable.
EXHIBIT 9.10 Note disclosure relating to the right-of-use assets of China Starch (Source: China Starch
Holdings Limited 2021 Annual Report, page 100.)
Exhibit 9.11 shows the note disclosure of China Construction Bank (Asia), a lessee of land,
buildings and equipment globally, in relation to their lease liabilities from their 2021 annual
report. In particular, the following amounts are disclosed in accordance with HKFRS 16:
• Interest expense on lease liabilities;
• The expense relating to variable lease payments that do not depend on an index
or rate; and
• Expenses relating to short term leases;
• Expenses relating to leases of low value assets; and
• Maturity analysis of contractual undiscounted cash flows.
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EXHIBIT 9.11 Extract of note disclosures relating to the lease liabilities of China Construction
Bank (Asia) (Source: China Construction Bank (Asia) 2021 Annual Report & Financial Statements, page 235.)
Neither China Starch nor China Construction Bank (Asia) disclose all amounts identified in
HKFRS 16 as possible disclosure items (e.g. income from subleasing; and gains or losses on sale
and leaseback transactions). This is not uncommon; not all disclosure items will be applicable
to a lessee.
Two exceptions exist to the above disclosure requirements. First, if right-of-use assets
constitute investment property, the lessee will apply the disclosure requirements of HKAS 40.
In doing so, the lessee is not required to disclose the following amounts (from preceding
information):
• Depreciation charge for right-of-use assets by class of underlying asset;
• Income from subleasing right-of-use assets;
• Additions to right-of-use assets; and
HKFRS • The carrying amount of right-of-use assets at the end of the reporting period by class of
16.56 underlying asset.
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Second, if the lessee adopts the revaluation model to measure right-of-use assets, the
HKFRS
lessee will disclose the information required by paragraph 77 of HKAS 16 for those
16.57 right-of-use assets.
In addition to the above disclosures, a lessee is also required to disclose the following:
• The amount of its short-term lease commitments if short-term lease commitments at
the end of the reporting period are dissimilar to the amount disclosed as the expense
HKFRS
relating to short-term leases with a lease term greater than one month (this presumes
16.55 the lessee has adopted the recognition exemption); and
HKFRS
• Additional qualitative and quantitative information about the lessee’s leasing activities
16.59 that contribute to achieving the objective of lessee disclosures.
Knowledge Check Question
Question 5
Continuing with the analysis of the lease between Home Supplies and Luxury:
(a) Calculate the subsequent measurement of the lease liability and right-of-use asset of
Home Supplies; and
(b) Prepare the journal entries to record those subsequent measurements by Home
Supplies at the end of the second year of the lease term.
Assume the CPI is 106 as of 31 December 20Y0.
Question 6
On 1 January 20X7, Quality Products Limited (Quality Products) enters into a lease with
Efficient X Limited (Efficient X) for the exclusive use of manufacturing equipment for four
years. Quality Products has the unconditional option to terminate the lease after three
years (i.e. on 31 December 20X9) at a penalty of HK$50,000. Quality Products will probably
exercise the option to terminate the lease. Annual lease payments are in advance,
commencing on 1 January 20X7, with a payment of HK$100,000. Each subsequent annual
payment equals HK$100,000 plus 2% of Quality Products’ last quarter sales. Efficient X is
guaranteed a residual value of HK$15,000 on the manufacturing equipment, payable if
Efficient X terminates the lease after three years. If the option to terminate is not exercised,
the guaranteed residual value is zero. The residual value is guaranteed by Quality Products.
The interest rate implicit in the lease is 3% per annum.
Calculate the initial measurement of the lease liability.
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Knowledge Check Questions (continued)
Question 7
On 1 January 20X6, Bambling Limited (Bambling) enters into a lease with Vertical Limited
(Vertical) for the exclusive use of a motor vehicle for three years. Annual lease payments
are HK$25,000, paid in arrears on 31 December. Bambling guarantees a residual value for
the motor vehicle at the end of the lease term of HK$7,500. The expected fair value of the
motor vehicle at the end of the lease term (i.e. as at 31 December 20X8) is HK$5,000. The
interest rate implicit in the lease is 5% per annum.
Calculate the subsequent measurement of the lease liability in each of the 3 years.
Question 8
On 1 January 20X5, Clear Communications Limited (Clear) enters into a lease with Signal
Limited (Signal) for the exclusive use of a mobile phone tower for 15 years. The agreement
contains a purchase option, enabling Clear to purchase the tower at the end of the lease
term. Clear is reasonably certain it will exercise the purchase option. The useful life of
the tower is 25 years with a scrap value of HK$650,000. Clear expects to consume the
economic benefits from the tower evenly over the period of use.
Based on the above and other information, the lease liability is initially measured at
HK$5,000,000, excluding an initial lease payment of HK$450,000 on commencement of
the lease.
Clear adopts the cost model in relation to its property, plant and equipment. On
31 December 20X5, there is no indication the mobile phone tower is impaired.
Calculate which of the following is the carrying amount of the right-of-use asset on
31 December 20X5.
A HK$4,666,667
B HK$4,826,000
C HK$5,086,667
D HK$5,258,000
9 . 4 LESSOR
HKFRS 16 adopts a dual lease accounting model for lessors because lessors are required to
classify their leases as operating or financing leases and, on doing so, account for each type of
lease differently.
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This section explores how a lessor is required to account for a lease in accordance
with HKFRS 16.
9.4.1 Classification of Leases
At the inception of a lease, a lessor is required to classify it as an ‘operating lease’ or a ‘finance
lease’. Whether a lease is an operating or finance lease depends on whether the lease
agreement transfers substantially all the risks and rewards incidental to ownership of the
HKRS 16.61, underlying asset to the lessee or not. If it does, it is a finance lease. If it does not, it is an
62, 66 operating lease. Classification of the lease occurs at inception date as this date coincides with
when the risks and rewards (if at all) incidental to ownership of the asset of the underlying
asset are first transferred to the lessee.
Risks incidental to ownership of the underlying asset include:
• The possibility of suffering losses due to idle capacity or technological
obsolescence; and
HKFRS
16.B53 • Variations in return due to changing economic conditions.
Rewards incidental to ownership of the underlying asset include:
• The expectation of profitable operation of the underlying asset over its
economic life; and
HKFRS • The expectation of any gain from appreciation in value of the underlying asset or
16.B53 realisation of its residual value.
If the above types of risks and rewards rest with the lessee, a finance lease exists. If they
are retained by the lessor, an operating lease exists.
HKFRS 16 also provides specific examples of situations in which the risks and rewards
incidental to ownership of the underlying asset would normally be regarded as having been
transferred to the lessee (i.e. a finance lease). These are as follows:
• The lease transfers ownership of the underlying asset to the lessee by the end of the
lease term;
• The lessee has the option to purchase the underlying asset at a price that is expected to
be sufficiently less than the fair value at the date the option becomes exercisable for it
to be reasonably certain, at inception date, that the option will be exercised;
• The lease term is for the major part of the economic life of the asset even if title is not
transferred;
• At inception date, the present value of the lease payments amounts to at least
substantially all of the fair value of the underlying asset; and
HKFRS • The underlying asset is of such a specialised nature that only the lessee can use it
16.63 without major modifications.
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HKFRS 16 also provides indicators of situations that could lead to a lease being classified as
a finance lease. These are as follows:
• If the lessee can cancel the lease, the lessor’s losses associated with the cancellation are
borne by the lessee;
• Gains or losses from the fluctuation in the fair value of the residual accrue to the lessee
(e.g. in the form of a rent rebate equalling most of the sales proceeds at the end of the
lease); and
HKFRS
• The lessee has the ability to continue the lease for a secondary period at a rent that is
16.64 substantially lower than market rent.
These examples and indicators may individually or collectively indicate the existence of a
HKFRS
finance lease. The assessment depends on the substance of the transaction rather than the
16.63, 64 form of the contract.
Though a lessor initially classifies a lease as operating or finance at the inception of the
lease, a reassessment can occur but only in the event of a lease modification. Recall that a
HKFRS
‘lease modification’ is a change in the scope of a lease, or the consideration for a lease, that was
16.App A not part of the original terms and conditions of the lease. Changes in estimates (e.g. of
HKFRS
economic life or residual value of the underlying asset) or circumstances (e.g. default by the
16.66 lessee) are not lease modifications and do not trigger a reassessment of the lease classification.
9.4.2 Finance Lease Accounting
How a lessor accounts for a finance lease in accordance with HKFRS 16 depends on the type of
lessor it is. Two types of lessors exist:
1. Financier lessors, who acquire the underlying asset at fair value to lease it to the lessee.
Financier lessors derive their profit from the financing arrangements within the lease
agreement (i.e. through finance income) rather than make a gain from the sale.
2. Manufacturer or dealer lessors. Manufacturers may lease out assets they have
produced rather than sell them. Similarly, dealers may acquire assets for resale but
instead choose to lease them to others. In either instance, the underlying asset is
generally recognised by the manufacturer or dealer lessor at an amount less than
its fair value. For example, the manufacturer or dealer will typically recognise the
underlying asset at cost. As the manufacturer or dealer seeks to profit from the
underlying asset, the price the underlying asset would have otherwise been sold
for (i.e. fair value) would exceed the asset’s cost. A manufacturer or dealer lessor,
therefore, will generate two types of income through a lease:
i. A selling profit, being the difference between the underlying asset’s cost and fair
value; and
ii. Like a financier lessor, finance income.
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To illustrate the difference between these two types of lessors, a finance company that
purchases an asset at fair value (e.g. land and buildings) and then leases it to a customer in
return for annual payments is a financier lessor. The lease payments charged by the finance
company will be calculated to recoup the purchase price of the asset plus interest, with
the latter representing the profit the company derives from the transaction. On the other
hand, a car manufacturer or dealer that decides to lease its motor vehicles, rather than sell
them, is a manufacturer or dealer lessor. The motor vehicles are typically recognised (as
inventory) at cost, with the lease payments charged by the manufacturer or dealer calculated
to recover the ‘lost’ profit that would have derived from selling the car (rather than leasing it)
plus interest.
This section initially discusses how a lessor, whether a financier or manufacturer or
dealer, accounts for a finance lease in accordance with HKFRS 16 followed by discussion (in
Section 9.4.2.3) of the additional HKFRS 16 requirements specific to manufacturer or dealer
lessors only.
9.4.2.1 Initial Measurement
Because a finance lease transfers substantially all the risks and rewards incidental to ownership
of the underlying asset to the lessee, a lessor must first, at commencement date, derecognise
the underlying asset from its statement of financial position.
In its place, the lessor recognises as an asset a receivable to reflect the payments the lessor
HKFRS will receive because of the lease. The receivable is first recognised at commencement date and
16.67 is measured at an amount equal to the net investment in the lease.
Present value of Present value of
Net investment
in the lease = future lease + any unguaranteed
payments residual value
EXHIBIT 9.12 Initial measurement of the net investment
in the lease
The net investment in the lease is calculated as the present value of the sum of future
lease payments receivable by the lessor and any unguaranteed residual value accruing to
the lessor (see Exhibit 9.12). In particular, the lessor’s net investment in the lease equals the
present value of the following estimated amounts receivable in the future:
• Fixed payments (including in-substance fixed payments) less any lease
incentives payable;
• Variable payments that depend on an index or rate;
• Amounts receivable under residual value guarantees, whether provided to the lessor
by the lessee, a party related to the lessee or a third party unrelated to the lessor that is
financially capable of discharging the obligations under the guarantee;
• The exercise price of a purchase option, but only if it is reasonably certain to be
exercised by the lessee;
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• Penalties to terminate the lease, but only if the lease term reflects the lessee exercising
the option to terminate; and
HKFRS
16.70 • Any unguaranteed residual value accruing to the lessor.
As evident from the preceding information, from the lessor’s perspective, the definition of
lease payments includes residual value guarantees beyond that provided by the lessee. From
HKFRS
16.App the lessee’s perspective, however, the definition of lease payments includes only those residual
A, 70 values guaranteed to be payable by the lessee.
Thus, though a significant overlap exists between the initial measurement of the net
investment in the lease by a lessor and the lease liability by a lessee, there are two notable
differences:
1. The net investment in the lease includes the present value of any unguaranteed
residual value accruing to the lessor, which is not included in the lessee’s lease liability
because it is not a present obligation of the lessee.
2. The net investment in the lease includes any residual value guaranteed to the lessor by
any party (e.g. the lessee, a party related to the lessee or an unrelated third party); the
lessee only includes any residual value it guarantees in the measurement of the lease
liability.
The lessor uses the interest rate implicit in the lease to discount the future cash inflows to
present value terms. The interest rate implicit in the lease is defined in such a way that any
HKFRS
initial direct costs incurred by the lessor are included automatically in the initial measurement
16.68–69 of the net investment in the lease. There is no need to add them separately.
The interest rate implicit in the lease is that which makes the net investment in the lease
equal to the fair value of the underlying asset plus initial direct costs of the lessor. That is,
the interest rate implicit in a lease is where the future value of future lease payments plus
the future value of any unguaranteed residual value are discounted by an interest rate such
that the resulting present value of future lease payments plus the present value of any
unguaranteed residual value equals the fair value of the underlying asset plus any initial direct
costs (Exhibit 9.13).
Present value Present value of
Fair value of the Initial direct
of future lease + any unguaranteed = underlying asset + costs of the lessor
payments residual value
EXHIBIT 9.13 Interest rate implicit in the lease is that which causes the following
equation to be true
9.4.2.2 Subsequent Measurement Including Lease Modifications
After lease commencement, the lessor recognises finance income (in profit or loss) over the
HKFRS lease term based on a pattern reflecting a constant periodic rate of return on the lessor’s net
16.75 investment in the lease. This is achieved by allocating the lease payments received by the lessor
between finance income to the lessor and the repayment of the ‘principal’ (i.e. the lease
receivable, being the net investment in the lease) using the interest rate implicit in the lease.
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FINANCIAL REPORTING
This approach is consistent with the subsequent measurement of a lease liability of a
lessee (described in Section 9.3.3.2). This is because the carrying amount of the net investment
in the lease will increase to reflect interest accrued (i.e. finance income) and decrease to reflect
lease payments received.
The derecognition and impairment requirements of HKFRS 9 apply to a lessor’s net
investment in the lease because it is a financial asset. Moreover, a lessor is required to regularly
review any estimated unguaranteed residual value used in computing the gross investment in
the lease (i.e. the undiscounted future lease payments plus the unguaranteed residual value).
If the unguaranteed residual value is reduced, the lessor revises the income allocation over the
HKFRS
lease term and immediately recognises (as an impairment) any reduction in respect of
16.77 amounts accrued.
A lessor that classifies an asset under a lease as held for sale in accordance with HKFRS 5
HKFRS
Non-current Assets Held for Sale and Discontinued Operations accounts for the asset in accordance
16.78 with HKFRS 5 (see Chapter 15).
A lessor accounts for a modification to a finance lease as a separate lease if:
• The modification increases the scope of the lease by adding the right to use one or
more underlying assets; and
HKFRS
• The consideration for the lease increases by an amount commensurate with the
16.79 stand-alone price for the increase in scope.
If a modification is not accounted for as a separate lease, it is accounted for as follows:
• If the lease would have been classified as an operating lease had the modification been
in effect at the inception date the lessor:
• Accounts for the lease modification as a new lease from the effective date of the
modification; and
• Measures the carrying amount of the underlying asset as the net investment in the
lease immediately before the modification took effect.
HKFRS
16.80 Otherwise, the lessor applies the requirements of HKFRS 9.
9.4.2.3 Manufacturer or Dealer Lessors
When a manufacturer or dealer enters into a finance lease with a lessee, additional HKFRS
16 requirements specific to the manufacturer or dealer lessor must be applied. These
requirements will now be considered.
Initial Measurement
HKFRS HKFRS 16 treats a finance lease for manufacturer or dealer lessors as an outright sale of the
16.72 underlying asset by the lessor to the lessee as that better reflects the economics of the
transaction. As such, in addition to the derecognition of the underlying asset and the
recognition of the net investment in the lease as an asset, at the commencement date, a
manufacturer or dealer lessor also recognises the following:
• Revenue, which is the lower of the fair value of the underlying asset and the present
value of the lease payments accruing to the lessor discounted using a market rate of
interest; and
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HKFRS
• The cost of sale, which is the cost (or carrying amount if different) of the asset less the
16.71 present value of the unguaranteed residual value.
HKFRS
16.71 The difference between revenue and cost of sale is a selling profit or loss (i.e. gain on sale).
Revenue is measured by taking the lower of the fair value of the underlying asset and the
present value of lease payments. Requiring the lessor to recognise revenue as the lower of
these two amounts prevents lessors overstating revenue at commencement date through, for
example, inflating the underlying asset’s selling price (i.e. fair value).
Similarly, in measuring revenue, lease payments are discounted to present value using a
market rate of interest. This is to overcome situations where a manufacturer or dealer lessor
quotes an artificially low rate of interest to attract customers and, if using this low rate of
HKFRS
interest as the discount rate, results in the lessor recognising an excessive portion of the total
16.73 income from the transaction as revenue at the commencement date.
Costs incurred in connection with obtaining a finance lease are recognised by a
manufacturer or dealer lessor as an expense at the commencement date, including those that
would otherwise constitute initial direct costs. As such, the measurement of the net investment
in the lease differs for a financier lessor and a manufacturer or dealer lessor because the
HKFRS
16.74. latter’s will not include any incremental costs of obtaining a lease that would not have been
App A incurred if the lease were not obtained.
Illustrative Example 10
Prestige Vehicles Limited (Prestige) manufactures motor vehicles for sale and lease.
On 1 January 20X0, Prestige leased a vehicle to Chauffeur Services Limited (Chauffeur),
incurring HK$15,000 in legal fees to negotiate, prepare and execute the lease agreement.
The motor vehicle cost Prestige HK$525,000 to manufacture, and its fair value at the
inception of the lease was HK$636,854. The lease term is three years, at the completion
of which Prestige has guaranteed HK$100,000 of the HK$155,000 expected residual value
to be receivable by Chauffeur. Ownership of the vehicle transfers to Chauffeur at the end
of the lease term. Annual lease payments are HK$175,000, commencing 31 December
20X0. Current market lending rates for a three-year loan are 3% per annum.
Looking at the substance of the transaction, the lease should be classified as a
finance lease by Prestige because the following facts, in combination, indicate a finance
lease exists:
• Ownership transfers to Chauffeur at the end of the lease term; and
• At inception date, the present value of the future lease payments (HK$586,521, per
the following) amounts to at least substantially all of the fair value of the underlying
asset (HK$636,854) (i.e. HK$586,521/HK$636,854 = 92.10%).
On weighing all relevant facts and focusing on the substance of the contract, the risks
and rewards incidental to ownership of the vehicle transfers to Chauffeur. As such, a
finance lease exists. In addition, Prestige constitutes a manufacturer lessor given that it has
leased out a vehicle it has manufactured it, rather than sell it, to Chauffeur.
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Illustrative Example 10 (continued)
On the initial measurement of the lease, Prestige is to derecognise the motor vehicle
as inventory at cost (HK$525,000). Prestige is to recognise the net investment in the lease
as an asset (termed lease receivable) which, per Exhibit 9.12, is equal to the sum of the
present value of future lease payments and any unguaranteed residual value accruing to
the lessor. The entire estimated residual value of the vehicle of HK$155,000 is included
in the initial measurement of the net investment in the lease because HK$100,000 is
guaranteed (and, therefore, falls within the scope of ‘future lease payments’), and the
remaining HK$55,000 is an unguaranteed residual value.
Based on a market interest rate of 3% per annum, the initial measurement of the net
investment in the lease is HK$636,854, calculated as follows:
Present value of lease payments
Payment Discount rate Present value
HK$ HK$
31 December 20X0 175,000 1/1.03 169,903
31 December 20X1 175,000 1/1.032
164,954
31 December 20X2 275,000 1/1.033 251,664
Present value of lease payments 586,521
Present value of unguaranteed residual value
Payment Discount rate Present value
HK$ HK$
31 December 20X2 55,000 1/1.033 50,333
Present value of unguaranteed 50,333
residual value
Net investment in the lease HK$586, 521 HK$50, 333 HK$636, 854.
The net investment in the lease corresponds with the fair value of the motor vehicle,
which is to be expected as knowledgeable willing parties in an arm’s-length transaction
are likely to agree that the transaction price equals the present value of future cash flows
generated by the vehicle.
Prestige also recognises revenue, equal to the lower of the fair value of the vehicle
(HK$636,854) and the present value of future lease payments (HK$586,521), and cost of
sales, which is the cost of the vehicle less the present value of the unguaranteed residual
value (i.e. HK$525,000 − HK$50,333 = HK$474,667). The legal fees of HK$25,000 are to be
HKFRS expensed because such costs incurred by manufacturer lessors are precluded from being
16.74.App A treated as initial direct costs under HKFR 16.
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Illustrative Example 10 (continued)
Based on the preceding information, Prestige would record the following journal entry
on 1 January 20X0:
Debit Credit
HK$ HK$
Lease receivable 636,854
Cost of sales 474,667
Legal fees 25,000
Sales revenue 586,521
Inventories 525,000
Cash 25,000
Subsequent Measurement
After lease commencement, a manufacturer or dealer lessor measures a finance lease in
accordance with the approach outlined in Section 9.4.2.2.
Key Learning Point
Lessors account for a lease arrangement by first classifying a lease into a finance or
operating lease. In principle, if rewards and risks from the use of the asset are sufficiently
transferred to the lessee, then the lease will represent a finance lease, whereas if the
rewards and risks rest with the lessor, then the lease will represent an operating lease.
9.4.3 Operating Lease Accounting
If a lessor retains substantially all the risks and rewards incidental to ownership of the
underlying asset, an operating lease exists. How a lessor accounts for an operating lease in
accordance with HKFRS 16 is discussed in the following section.
9.4.3.1 Recognition, Measurement and Modifications
The accounting treatment of operating leases by a lessor can be summarised as follows:
• Lease payments receivable from the lessee are recognised as income on either a
straight-line basis over the lease term or another systematic basis if it is more
HKFRS representative of the pattern in which benefits from the use of the underlying asset by
16.81 the lessor is diminished;
• The underlying asset subject to the operating lease continues to be recognised as an
HKFRS asset in the statement of financial position and depreciated in accordance with HKAS 16
16.84 or HKAS 38;
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HKFRS
• Initial direct costs incurred are added to the carrying amount of the underlying asset
16.83 and depreciated over the lease term on the same basis as the lease income; and
HKFRS
16.85 • The underlying asset is subject to impairment in accordance with HKAS 36.
A modification to an operating lease is accounted for as a new lease from the effective date
of the modification. At the time of the modification, the lessor assesses whether the new lease
is to continue to be classified as an operating lease or to be reclassified as a finance lease. Any
HKFRS
prepaid or accrued lease payments relating to the original lease are considered as part of the
16.66, 87 lease payments of the new lease.
9.4.3.2 Presentation
HKFRS Underlying assets subject to operating leases are presented in the lessor’s statement of
16.88 financial position according to the nature of the underlying asset.
Key Learning Point
The measurement of the value of an operating lease differs from the measurement of the
value of a finance lease in that the underlying asset is recognised as an asset under an
operating lease, but under a finance lease, it is recognised as a receivable.
9.4.4 Disclosures
The disclosures required by a lessor under HKFRS 16 depend on the classification of the lease.
9.4.4.1 Finance Leases
For finance leases, a lessor discloses the following amounts for the reporting period:
• Selling profit or loss (if it is a manufacturer or dealer lessor);
• Finance income on the net investment in the lease; and
HKFRS • Income relating to variable lease payments not included in the measurement of the net
16.90(a) investment in the lease.
HKFRS The above disclosures are to be provided in tabular format unless another format is more
16.91 appropriate.
In addition to the above disclosures, a lessor is also required to disclose the following:
HKFRS • Qualitative and quantitative information about the lessor’s leasing activities that
16.92(a) contribute to achieving the objective of lessor disclosures;
HKFRS • Qualitative and quantitative explanation of the significant changes in the carrying
16.93 amount of the net investment in finance leases; and
• Maturity analysis of the lease payments receivable, showing undiscounted lease
payments to be received annually for at least each of the first five years and a total of
the amounts to be received for the remaining years. In addition, a lessor shall reconcile
the undiscounted lease payments to the net investment in the lease, identifying the
HKFRS unearned finance income relating to the lease payments receivable and any discounted
16.94 unguaranteed residual value.
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Exhibit 9.14 shows an illustrative disclosure of a maturity analysis of lease payments
receivable by a lessor, showing:
• Undiscounted lease payments to be received annually for each of the five years of the
lease term and a total of the amounts to be received for the remaining years; and
• A reconciliation of the undiscounted lease payments to the net investment in the lease,
identifying the unearned finance income relating to the lease payments receivable.
2019
(in HK$’000)
Less than one year 880
One to two years 880
Two to three years 880
Three to four years 880
Four to five years 880
More than five years 3,520
Total undiscounted lease payments receivable 7,920
Unearned finance income (470)
Net investment in the lease 7,450
EXHIBIT 9.14 Illustrative disclosure of maturity analysis of lease
payments receivable by a lessor
9.4.4.2 Operating Leases
HKFRS
16.90(b) For operating leases, a lessor discloses lease income, separately disclosing income relating to
HKFRS variable lease payments that do not depend on an index or rate. This is to be disclosed in
16.91 tabular format unless another format is more appropriate.
In addition, a lessor is also required to disclose the following:
HKFRS • Qualitative and quantitative information about the lessor’s leasing activities that
16.92(a) contribute to achieving the objective of lessor disclosures;
• How the lessor manages the risk associated with the rights it retains in underlying
assets. In particular, a lessor discloses its risk management strategy for the rights it
retains in underlying assets, including the means by which the lessor reduces that risk,
HKFRS for example, buy-back agreements, residual value guarantees or variable lease
16.92(b) payments for use in excess of specified limits;
• The disclosures required by HKAS 16 for items of property, plant and equipment
subject to an operating lease, disaggregating each class of property, plant and
equipment into assets subject to operating leases and those that are not. As such,
within each class of property, plant and equipment, the disclosures required by
HKFRS HKAS 16 are to be provided separately for assets subject to an operating lease and
16.95 those owned assets that are held and used by the lessor;
HKFRS • The disclosures required by HKAS 36, HKAS 38, HKAS 40 and HKAS 41 for assets subject
16.96 to operating leases; and
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FINANCIAL REPORTING
• A maturity analysis of lease payments, showing undiscounted lease payments to be
HKFRS
received annually for at least each of the first five years and a total of the amounts to be
16.97 received for the remaining years.
Knowledge Check Questions
Question 9
On 1 January 20X7, Ahoy Limited (Ahoy) leased a cargo ship to TransPacific Limited
(TransPacific) for 30 years. Though the lease is for the exclusive use of a specific cargo
ship over the term of the lease, the design of the cargo ship is generic to meet the varying
transportation needs of distributors, such as TransPacific. For the duration of the lease
term, TransPacific is required to make annual lease payments in arrears of HK$200,000.
Though ownership does not automatically transfer to TransPacific at the end of the lease
term, it has the option to purchase the cargo ship for HK$500,000. The fair value of the
cargo ship at the end of the lease term is estimated to be HK$750,000. Using an implicit
interest rate of 5% per annum, the present value of the annual fixed payments and the
exercise price for the purchase option is HK$3,190,179. On 1 January 20X7, the fair value of
the cargo ship is HK$3,200,000. The estimated economic life of the cargo ship is 35 years.
Determine how Ahoy should classify the lease agreement with TransPacific.
Question 10
On 1 January 20X6, Plus Signs Limited (Plus Signs, the lessor) enters into an agreement
to lease a warehouse to Prime Success Limited (Prime Success, the lessee) for four years.
Prime Success has the unconditional option to terminate the lease after two years at a
penalty of HK$75,000. Plus Signs is reasonably certain Prime Success will not exercise the
option to terminate the lease. Annual lease payments are in advance, commencing on
1 January 20X6, with a payment of HK$125,000. Each subsequent annual payment equals
HK$125,000 plus the change in the CPI since the end of the previous year. The CPI as of
31 December 20X5 is 100. Plus Signs estimates the residual value of the warehouse at the
end of the lease term to be HK$350,000, half of which is guaranteed by Prime Success. The
interest rate implicit in the lease is 4% per annum.
Calculate the initial measurement of the net investment in the lease.
9 . 5 SALE AND LEASEBACK TRANSACTION
ACCOUNTING
In a sale and leaseback transaction, an asset is transferred by an entity (the seller-lessee) to
another entity (the buyer-lessor) and then leased back by the seller-lessee. A seller-lessee may
instigate a sale and leaseback transaction to generate cash from the asset transfer while still
retaining use of the asset. Prior to the introduction of accounting standards governing sale and
leaseback transactions, the seller-lessee could enter into sale and leaseback transactions to
potentially artificially inflate profits and keep assets and liabilities off the statement of financial
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position. For example, the seller-lessee recognised revenue from the sale of the asset despite
the seller-lessee continuing to use the asset as it did prior to the sale. Moreover, despite the
continued use of the asset, the seller-lessee was no longer required to recognise the asset
(as it has been ‘sold’) nor to recognise the obligation to pay the buyer-lessor for the use of the
asset as a liability because lease assets and lease liabilities were not required to be recognised
by a lessee.
How a seller-lessee and buyer-lessor now account for a sale and leaseback transaction
is according to the substance of the transaction and depends on whether the asset transfer
constitutes a sale or not.
9.5.1 Assessing Whether the Transfer of the Asset Is a Sale
In determining whether the transfer of an asset is accounted for as a sale (purchase) of that
asset, the seller-lessee (buyer-lessor) applies HKFRS 15 to determine whether control of the
asset has transferred to the buyer-lessor. Both parties apply HKFRS 15 to determine whether
HKFRS and, if so, when the seller-lessee satisfies a performance obligation, thereby transferring
16.99 control of the asset.
See Chapter 5, Section 5.2.5 (Recognising Revenue When (or As) the Entity Satisfies a
Performance Obligation – Step 5) for further discussion of the HKFRS 15 requirements for
determining when a performance obligation is satisfied.
9.5.1.1 When Transfer of the Asset Is a Sale
If control of an underlying asset passes to the buyer-lessor, the transaction is accounted for as
a sale (purchase) by the seller-lessee (buyer-lessor) and a lease between both parties.
Each party accounts for the transaction as follows:
• Seller-lessee
°° recognises the sale proceeds as an increase in cash at bank or receivables;
°° derecognises the transferred asset;
°° recognises a gain or loss on the proportion of the previous carrying amount of the
transferred asset that relates to the rights transferred to the buyer-lessor;
°° recognises a right-of-use asset arising from the leaseback, equal to the proportion
of the previous carrying amount of the transferred asset (now derecognised) that
relates to the right of use retained by the seller-lessee; and
HKFRS °° recognises a lease liability, equal to the present value of future lease payments
16.100(a) (as described in Section 9.3.3.1.1).
• Buyer-lessor
°° recognises the purchased asset in its statement of financial position in accordance
with applicable HKFRSs; and
HKFRS °° accounts for the lease in accordance with the lessor accounting requirements in
16.100(b) HKFRS 16 (as described in Section 9.4).
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Illustrative Example 11
On 1 January 20X1, Cyber Surveillance Limited (Cyber) transfers a building it owns to
Finance Now Limited (Finance Now) for cash of HK$2,500,000, which is equal to the
fair value of the building. Immediately before the transfer, the carrying amount of
the building is HK$1,500,000. Immediately following the transfer, Cyber leases back
the building under a five-year lease. As part of the transaction, Cyber has transferred
physical possession of the building and substantially all risks and rewards of ownership
of the building. Finance Now also has legal title to the building. Annual lease payments,
payable in arrears, are HK$250,000. There is neither guaranteed residual value nor any
purchase or termination options. The implicit interest rate is 3% per annum. The present
value of the annual lease payments amounts to HK$1,144,927. The pattern of benefits to
Cyber from use of the building is constant over the lease term. The depreciation policy of
Finance Now is to depreciate all depreciable assets on a straight-line basis. This example
ignores any initial direct costs.
In this case, Cyber is the seller-lessee and Finance Now is the buyer-lessor. In
accordance with HKFRS 15, the transfer of the building is a sale because Cyber has
transferred control of the building. This is indicated by Cyber transferring physical
possession and substantially all the risks and rewards of ownership of the building.
Moreover, Finance Now has legal title to the building. As such, the transaction is to be
accounted for in the records of Cyber and Finance Now as follows.
Cyber (seller-lessee)
At the commencement date, Cyber is required to measure the right-of-use asset as a
HKFRS proportion of the carrying amount of the derecognised building that relates to the rights
16.IE24 retained to continue to use the building. This is calculated using the following formula:
Carrying amount of the building
Present value of future lease payments
Fair value of the building
In the context of Cyber, the initial measurement of the right-of-use asset is as follows:
HK$1, 500, 000
HK$1144
, , 927 HK$686, 956
HK$2, 500, 000
An alternative way of expressing this formula, yet deriving the same answer is
as follows:
Present value of future lease payments
Carrying amount of the building
Fair value of the buiilding
The remaining portion of carrying amount of the building (HK$1,500,000 − HK$686,956 =
HK$813,044) represents the rights transferred to Finance Now. Though there is an overall
gain on sale of the building totalling HK$1,000,000 (HK$2,500,000 − HK$1,500,000), Cyber
HKFRS recognises only that portion of the gain that relates to the rights transferred to Finance Now.
16.IE24 To calculate that portion of the gain, Cyber would use the following formula:
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Illustrative Example 11 (continued)
Gain on sale of the building Fairr value of the building
Fair value of the building Present value of future lease paymments
In the context of Cyber, the gain on the rights transferred to Finance Now is as follows:
HK$1, 000, 000
(HK$2, 500, 000 HK$1144
, , 927) HK$542, 029
HK$2, 500, 000
Alternatively, this formula can be expressed as follows:
(Fair value of the building Present value of future lease payments)
Gain on sale
Fair value of the building
The remaining portion of the gain on sale of the building (HK$1,000,000 − HK$542,029
= HK$457,971) relates to the rights retained by Cyber to use the building, and therefore is
not recognised as a gain.
Remembering that, in addition to the preceding information, Cyber is to recognise
the sale proceeds as an increase in cash at bank (HK$2,500,000), derecognise the building
(HK$1,500,000) and recognise a lease liability equal to the present value of future lease
payments (HK$1,144,927), Cyber will account for the sale and leaseback transaction at the
commencement date of 1 January 20X1 as follows:
Debit Credit
HK$ HK$
Cash 2,500,000
Right-of-use asset 686,956
Building 1,500,000
Gain on rights transferred 542,029
Lease liability 1,144,927
Subsequently, the carrying amount of the financial liability will increase due to annual
interest accretion and decrease when the annual lease payments are made. The carrying
amount of the financial liability at the end of each year following lease commencement is
as follows:
Beginning Payment Interest Ending balance
balance expense (3%) (31/12 each year)
(1/1 each year)
HK$ HK$ HK$ HK$
31 December 20X1 1,144,927 250,000 34,348 929,275
31 December 20X2 929,275 250,000 27,878 707,153
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FINANCIAL REPORTING
Illustrative Example 11 (continued)
Beginning Payment Interest Ending balance
balance expense (3%) (31/12 each year)
(1/1 each year)
31 December 20X3 707,153 250,000 21,215 478,368
31 December 20X4 478,368 250,000 14,351 242,719
31 December 20X5 242,719 250,000 7,281a 0
a
Balancing item that contains rounding error of HK$1.
To illustrate, at the end of the first year of the lease (31 December 20X1), the lease
payment reduces the finance liability by HK$250,000. However, interest accretion for the
year is HK$34,348 (HK$1,144,927 × 3%), giving rise to a ‘net’ reduction in the finance liability
of HK$215,652 (HK$250,000 − HK$34,348). This reduces the carrying amount of the finance
liability to HK$929,275.
Cyber would also depreciate the right-of-use asset over the lease term (five years). As
the pattern of benefits derived by Cyber from use of the building is constant over the lease
term, depreciation is on a straight-line basis. Depreciation expense equals HK$137,391
(HK$686,956/5 years).
Assuming no indication of impairment exists, the journal entry that Cyber would record
on 31 December 20X1 would be as follows:
Debit Credit
HK$ HK$
Lease liability 215,652
Interest expense 34,348
Cash 250,000
Depreciation – right-of-use asset 137,391
Accumulated depreciation – right-of-use asset 137,391
Cyber would perform the same journal entry on 31 December each year, with only the
apportionment of the HK$250,000 payment between interest expense and the reduction in
the financial liability varying according to the above payment schedule.
Finance Now (buyer-lessor)
As control of the building has been transferred to Finance Now including substantially all
the risks and rewards of ownership, Finance Now would treat the lease as an operating
lease. Finance Now recognises the purchase of the building with the following journal
entry on 1 January 20X1:
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Leases
Illustrative Example 11 (continued)
Debit Credit
HK$ HK$
Building 2,500,000
Cash 2,500,000
Subsequently, Finance Now recognises the lease payments from Cyber as lease
income. As Finance Now depreciates all depreciable assets on a straight-line basis, it is
reasonable to presume the diminution in value of the building would also be constant. As
such, lease income would be recognised on a straight-line basis and the journal entry on
31 December 20X1 would be:
Debit Credit
HK$ HK$
Cash 250,000
Lease income 250,000
This journal entry would be performed by Finance Now on 31 December for each year
of the lease term.
The building is depreciated by Finance Now. Presuming the building is depreciated on
a straight-line basis over 20 years, the journal entry on 31 December 20X1 would be:
Debit Credit
HK$ HK$
Depreciation - Building 125,000
Accumulated depreciation - Building 125,000
This journal entry would be performed by Finance Now on 31 December for each year
of the building’s economic life.
Instances may occur where the transaction between the seller-lessee and the buyer-
lessor is not on market terms. In particular, the sale proceeds might be above or below the
fair value of the transferred asset, or the lease payments might not be at market rates. From
the perspective of the seller-lessee, these off-market terms could lead to distortions in the
measurement of the right-of-use asset (including depreciation charges), the gain or loss on sale
of the transferred asset, and the measurement of the lease liability (including interest expense).
From the perspective of the buyer-lessor, these off-market returns could lead to distortions
in the lease income. To help prevent these distortions from occurring, HKFRS 16 requires the
adjustments to be accounted for as set out in Exhibit 9.15.
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FINANCIAL REPORTING
Type of distortion Adjustment
Sale proceeds below fair value of transferred asset Account for as a prepayment of
lease payments
Lease payments below market rates
Sale proceeds above fair value of transferred asset Account for as additional financing provided
HKFRS by buyer-lessor to seller-lessee
16.101 Lease payments below market rates
EXHIBIT 9.15 Adjustments to sale and leaseback transactions not on market terms
The amount of the adjustment is equal to whichever of the following is more readily
determinable:
• The difference between the sale proceeds and the fair value of the transferred
asset; and
HKFRS • The difference between the present value of the contractual lease payments and the
16.102 present value of lease payments at market rates.
9.5.1.2 When Transfer of the Asset Is Not a Sale
If control of an underlying asset does not pass to the buyer lessor, no sale is recognised by
the seller lessee and no purchase is recognised by the buyer lessor. Instead, the transaction is
accounted for in accordance with its substance as only a financing arrangement. Indeed, strictly
speaking the arrangement is not a lease. Each party accounts for the transaction as follows:
• Seller-lessee
°° continues to recognise the transferred asset in its statement of financial position
(i.e. it is not derecognised); and
°° recognises a financial liability in its statement of financial position equal to the
transaction proceeds. The financial liability is accounted for in accordance with
HKFRS HKFRS 9 with the finance payments comprising interest expense and a reduction of
16.103(a) the financial liability.
• Buyer-lessor
°° does not recognise the transferred asset in its statement of financial position; but
°° rather recognises a financial asset (i.e. a receivable) in its statement of financial
position equal to the transaction proceeds. When the transfer of an asset is not a
sale the transaction proceeds equates to the present value of future finance
payments. The financial asset is accounted for in accordance with HKFRS 9 with the
HKFRS finance payments received comprising finance income and a reduction of the
16.103(b) receivable.
Exhibit 9.16 summarises the accounting for a sale and leaseback transaction in the form of
a decision tree.
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Leases
Transfer of asset
Seller-lessee Buyer-lessor
Asset leased back
Does the transfer constitute a sale?
YES NO
Seller-lessee Buyer-lessor ‘Seller-lesses’ ‘Buyer-lessor’
Derecognise Recognise Continue to Do not recognise
transferred asset transferred asset recognise transferred asset
Recognise right-of- Apply HKFRS 16 transferred asset Recognise a
use asset lessor accounting Recognise a financial asset
Recognise lease requirements financial liability per HKFRS 9
liability per HKFRS 9
Recognise gain/loss
on sale
EXHIBIT 9.17 How to account for a sale and leaseback transaction
Knowledge Check Question
Question 11
On 1 January 20X2, TopLine Limited (TopLine) transfers equipment it owns to Money
Managers Limited (Money Managers) for cash of HK$490,000, which is equal to the
fair value of the building. Immediately before the transfer, the carrying amount of the
equipment is HK$450,000. Immediately following the transfer, TopLine leases back
the equipment under a three-year lease. TopLine has retained physical possession of the
equipment and substantially all risks and rewards of ownership of the building. Annual
payments, payable in arrears, by Topline are HK$180,000. There is no guaranteed residual
value nor any purchase or termination options. The implicit interest rate is 5% per annum.
The pattern of benefits to TopLine from use of the equipment is constant over the lease
term. The depreciation policy of TopLine is to depreciate all depreciable assets on a
straight-line basis. The remaining useful life of the equipment is eight years. This example
ignores any initial direct costs.
Explain how TopLine and Money Managers would account for the transaction.
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FINANCIAL REPORTING
9 . 6 CURRENT DEVELOPMENTS
HKFRS 16 is a relatively new accounting standard, applying to annual periods from 1 January
2019. As such, the fundamental issue currently facing practice centres on how prepared
existing lessees and lessors are for HKFRS 16. The IASB has signalled that it plans to conduct a
post implementation review (PIR) on IFRS 16 Leases. It is too early to judge what impacts that
review might have.
In addition, the IASB has one active project on its agenda relating to IFRS 16 (Exhibit 9.17).
Project About the project
Lease Liability in a Sale Currently, IFRS 16 includes no specific subsequent measurement
and Leaseback requirements for sale and leaseback transactions. To clarify how a
seller-lessee subsequently measures the lease liability that arises
from a sale and leaseback transaction and, in doing so, reduce any
diversity in practice that currently exists, the IASB has proposed to add
subsequent measurement requirements to IFRS 16 for sale and leaseback
transactions. To facilitate these requirements, the IASB has also proposed
specifying the method a seller-lessee uses in initially measuring the right-
of-use asset and liability arising in such transactions.
The proposed amendments to IFRS 16 are contained in the Exposure
Draft (ED) Lease Liability in a Sale and Leaseback, which was published by
the IASB in November 2020, and apply to sale and leaseback transactions
where the transfer of the asset satisfies the requirements to be
accounted for as a sale of the asset.
The ED clarifies that:
• in initially measuring the right-of-use asset from the leaseback, the
seller-lessee is to determine the proportion of the previous carrying
amount of the asset that relates to the right of use retained by
comparing the present value of the expected lease payments to the
fair value of the asset sold; and
• the seller-lessee is to initially measure a lease liability at the present
value of the expected lease payments that are not paid at the
commencement date.
Of note is that the expected lease payments comprise, amongst
others, variable lease payments regardless of whether they depend on an
index or a rate.
Having clarified the initial measurement of the right-of-use asset
and lease liability, the ED specifies that the right-of-use asset is to be
subsequently measured using the existing requirements in IFRS 16
(namely, paras 29–35), while the lease liability is to be subsequently
measured as follows:
• increasing the carrying amount to reflect interest on the lease
liability;
• reducing the carrying amount to reflect the expected lease payments
for the reporting period as determined at the commencement date
or, if the lease liability has been remeasured, the revised expected
lease payments for the reporting period as determined at the date of
remeasurement;
EXHIBIT 9.17 Current active project for IFRS 16
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Project About the project
Lease Liability in a Sale • remeasuring the carrying amount to reflect reassessments or lease
and Leaseback modifications, excluding remeasurement that would otherwise
occur due to changes in variable lease payments resulting from
a change in an index or rate. For a change in the lease term or a
lease modification, the revised lease payments shall be the revised
expected lease payments at the date of remeasurement; and
• recognising any difference between the actual payments made for
the lease (excluding any above-market terms described in paragraph
101(b)) and the expected lease payments for the reporting period in
profit or loss. If there are shortfalls in the actual payments made (i.e.
the payments made are less than the payments due) or recoveries
of shortfalls, the seller-lessee shall also adjust the carrying amount
of the lease liability and recognise the corresponding amount in
profit or loss.
You can follow the project on the IASB website at:
https://www.ifrs.org/projects/work-plan/lease-liability-in-a-sale-and-
leaseback/#current-stage
EXHIBIT 9.17 (Continued)
An amendment to IFRS 16 for this issue is expected to be issued in September 2022 with an
application date of annual reporting periods beginning on or after 1 January 2024.
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SUMMARY
• HKFRS 16 sets out the principles for the definition, recognition, measurement, presentation
and disclosure of leases from the lessee’s and lessor’s perspective.
• Under HKFRS 16, a lease exists if there is a contract whereby the lessee has the right to control
the use of an identified asset for a period of time in exchange for consideration payable to
the lessor.
• If the contract contains non-lease aspects to it, the lessee (subject to a practical expedient)
and lessor allocate the total contract consideration between the lease and non-lease
components of the contract.
• If a lease exists, the term of the lease commences when the underlying asset becomes
available for use by the lessee and comprises any non-cancellable period and periods covered
by an option to extend or terminate the lease depending on the likelihood of the option being
exercised by the lessee.
• A lessee and lessor disclose information that, together with the information provided in the
financial statements, enables users to assess the effect of leases on the financial position,
financial performance and cash flows of lessee and lessor, respectively.
Lessee
• A lessee is required to recognise a right-of-use asset and a lease liability arising from the lease.
• The right-of-use asset is initially measured at cost but can be subsequently revalued if the
right-of-use asset relates to a class of property, plant and equipment to which the lessee
applies the revaluation model. It is also subject to depreciation and impairment requirements.
• The lease liability is initially measured at the present value of lease payments payable to the
lessor and changes in value over the lease term when interest expense accrues on the liability
and when lease payments are made or revised. The lease liability is discounted to present
value terms using the interest rate implicit in the lease or, if the implicit interest rate cannot
be readily determined by the lessee, the discount rate to use is the lessee’s incremental
borrowing rate.
• Generally, a lessee is required to present (or at least disclose) its right-of-use assets separately
from other assets, and its lease liabilities separately from other liabilities, in its statement of
financial position.
• A lessee can elect not to recognise a right-of-use asset and a lease liability for short-term
leases (12 months or less) or leases of low-value assets.
Lessor
• At the inception of the lease, a lessor must classify a lease as an operating or finance lease
according to whether substantially all of the risks and rewards incidental to ownership of the
leased asset are transferred to the lessee or not.
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• If substantially all the risks and rewards are transferred to the lessee, a finance lease exists
and the lessor recognises a receivable equal to the net investment in the lease.
• The net investment in the lease is initially measured at the present value of future lease
payments and any unguaranteed residual value accruing to the lessor. Subsequently, it
changes in value over the lease term when finance income accrues on the receivable, when
lease payments are received, the receivable is impaired, or certain lease modifications occur.
• If it is an operating lease, the lessor recognises finance income over the lease term on a
straight-line basis or another systematic basis.
Sale and Leaseback Transactions
• Sale and leaseback transactions occur when an asset is transferred by the seller-lessee to
the buyer-lessor and then leased back by the seller-lessee. Whether the asset transfer is
accounted for as a sale by the seller-lessee or a purchase by the buyer-lessor depends on
if and when a performance obligation has been satisfied by the seller-lessee in accordance
with HKFRS 15.
• If the asset transfer is a sale, the seller-lessee derecognises the asset sold, recognises a
right-of-use asset and lease liability, and recognises a gain or loss on the rights transferred to
the buyer-lessor on the sale. The buyer-lessor recognises the asset purchased and accounts
for the lease as either an operating or finance lease.
• If the asset transfer is not a sale, the seller-lessee recognises a financial liability and the
buyer-lessor recognises a finance asset the asset sold, both of which are accounted for in
accordance with HKFRS 9 (rather than as a lease).
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FINANCIAL REPORTING
MIND MAP
SCOPE DOES A LEASE EXIST?
Inclusions Assess at inception of contract (1) identified
• Leases asset; (2) right to control its use for a period
• Leases of right-of-use assets in a sublease Reassess only if terms and conditions change
Exclusions
UNIT OF ACCOUNT
• HKFRS 6 or HKAS 41 leases
• HK(IFRIC)-Int 12 service concession Assess at inception of lease
arrangements Account separately for each lease and in
• HKFRS 15 licences of Intellectual Property aggregate for non-lease components. Have
• HKAS 38 licensing agreements for certain regard to whether non-lease component
intangibles provides a service or not. Allocate contract
PRESENTATION AND DISCLOSURE consideration.
Lessee practical expedient: Treat lease
Presentation component and associated non-lease
• Lessee choice (not for investment property): component as one
Present right-of-use asset (lease liability)
separately or together with underlying Lease modification: Treat as new lease or
asset (other liabilities) adjustment of existing lease
• Lessee presents separately: interest LEASES LEASE TERM
expense, depreciation (HKFRS 16)
• Cash payments for principal or interest Assessed at commencement of lease
portion of a lease liability = CFS financing Lease term
activities (follow HKAS 7 interest paid • Non-cancellable period
classification) + Extension option period (if lessee
Disclosure reasonably certain to exercise option)
• Entity-specific + Termination option period (if lessee is
• Enables users to assess the effect of leases reasonably certain not to exercise option)
on the financial position, financial Reassess: (1) significant event occurs; or
performance and cash flows (2) significant change in circumstances
LESSOR LESSEE
Classify lease as operating or finance lease Recognise right-of-use asset and lease liability
• Does the lease transfer substantially all Right-of-use asset
risks and rewards incidental to ownership • Initially measured at cost (PV current and
to lessee? future lease payments + initial direct
• If yes, finance lease. If no, operating lease costs + dismantling costs)
Finance lease • Subsequently measured using cost or
• Derecognise underlying asset revaluation model
• Recognise receivable (net investment in • Subject to depreciation and impairment
the lease), initially measured as PV of (1) Lease liability
future lease payments to be received + (2) • Initially measured at PV future lease
any guaranteed residual value payments
• Recognise finance income on receivable • Subsequently: Carrying amount changes
• Manufacturer/dealer lessor: Recognise due to (1) interest accretion; (2) lease
revenue and cost of sale. Difference = selling payments made
profit or loss • Remeasure only if changes in future lease
Operating lease payments and lease modifications not
• Recognise lease payments as lease income accounted for as a separate lease
on a straight-line or another systematic basis Recognition exemptions: Practical expedients
SALE AND LEASEBACK • (1) Short-term lease (≤12 months) and
(2) low-value underlying asset
Assess whether asset transfer = HKFRS 15 sale • Recognise lease payments as lease expense
Transfer is a sale – accounting on a straight-line or another systematic basis
• Sale (purchase) by the seller-lessee (buyer-lessor);
• Lease agreement between both parties
• Seller-lessee recognises (1) right-of-use asset (2) lease liability
(3) gain or loss on rights transferred
• Buyer-lessor recognises (1) underlying asset (2) accounts for
lease as operating or finance lease
Transfer is not a sale – accounting
• Financing arrangement between seller-lessee (buyer-lessor)
• Seller-lessee recognises underlying asset and HKFRS 9 financial liability
• Buyer-lessor recognises HKFRS 9 financial asset and finance income
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Answers to Knowledge Check Questions
Question 1
Answer A is incorrect. This contract is an example of a lease arrangement that is within the
scope of HKAS 41 Agriculture.
Answer B is incorrect. A contract to explore for oil is outside the scope of HKFRS 16
because it is in relation to mineral resources and governed by HKFRS 6 Exploration for and
Evaluation of Mineral Resources.
Answer C is incorrect. This is a licensing agreement for a theatrical play. Such agreements
are governed by HKAS 38 Intangible Assets and, as such, are outside the scope of HKFRS 16.
Answer D is correct. A lease agreement between a retailer and a shopping centre operator
does not fall within the specific requirements of other standards and, as such, is within the
scope of HKFRS 16.
Question 2
The amount of the pipeline’s capacity that Oil and Gas has the right to use is not physically
distinct. As such, for it to constitute an identified asset, the amount of the pipeline’s
capacity that Netra has the right to use, as specified in the contract, must represent
substantially all the capacity of the pipeline. ‘Substantially all’ is not defined in HKFRS,
and therefore, professional judgement needs to be applied. If, for example, Netra can
use 90% of the pipeline’s capacity for the eight years of the contract this would represent
substantially all of the capacity of the pipeline. As such, an identified asset would exist
as Netra has the right to obtain substantially all the economic benefits from use of
the pipeline.
Question 3
No. This is even though the airline owner’s substitution rights are not substantive;
the airline owner is only able to substitute the identified asset if it is in need of repair.
However, although it is an ‘identified asset’, the airline company does not have a right to
obtain substantially all the economic benefits from use of the identified asset over the
three-year period. This is because the airline company can only use the aircraft for three
days a week with the airline owner benefitting from the use of the aircraft on the other
four days.
Question 4
Answer A is correct. The lease term begins at the commencement date of the lease, which
is when the retail space becomes available to Label for use: 1 August 20X7. Though the
lease is for a five-year period, Label has the right to terminate the lease after two years. At
the commencement of the lease, Label will probably terminate the lease because the right
to terminate is unconditional, significant amounts have not been spent on the retail space
by Label as only minor modifications have been made, there are no penalties to terminate,
and Label has an economic incentive to terminate the lease to avoid the above-market
impending variable lease payment increase.
Answer B is incorrect. The lease term begins at the commencement date of the lease,
which is when the retail space becomes available to Label for use and not when it is
first used.
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FINANCIAL REPORTING
Answer C is incorrect. The lease term does not begin at the inception date of the lease
(1 July 20X7), but rather the commencement date of the lease (1 August 20X7).
Answer D is incorrect. Though the lease term commences when the retail space becomes
available to Label for use (1 August 20X7), at the commencement of the lease it seems
reasonably certain Label will terminate the lease after two years for the preceding reasons.
Question 5
On 31 December 20X0, the carrying amount of the lease liability is HK$1,155,178
(HK$1,110,748 plus interest accretion at 4%). The interest accretion
(HK$1,110,748 × 4% = HK$44,430) on the lease liability in the second year is accounted for
with the following journal entry:
Debit Credit
HK$ HK$
Interest expense 44,430
Lease liability 44,430
Due to a change in the CPI over the previous 12 months, in accordance with the lease
agreement, the annual lease payments subsequent to 31 December 20X0 are adjusted to
HK$318,000 (HK$306,000 × (106/102)), and the lease liability is remeasured as follows:
Payment Discount rate Present value
HK$ HK$
1 January 20Y1 318,000 318,000
1 January 20Y2 318,000 1/1.04 305,769
1 January 20Y3 318,000 1/1.042 294,009
1 January 20Y4 318,000 1/1.043 282,701
Lease Liability 1,200,479
Accordingly, Home Supplies increases the lease liability by HK$45,301, which is the
difference between the remeasured lease liability (HK$1,200,479) and its previous carrying
amount (HK$1,155,178). There is a corresponding adjustment to the right-of-use asset as
reflected in the following journal entry on 31 December 20X0:
Debit Credit
HK$ HK$
Right-of-use asset 45,301
Lease liability 45,301
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The depreciation expense for 20Y0 is based on the carrying amount of the right-of-use
asset following its adjustment for the 20X9 remeasurement of the lease liability
(i.e. HK$1,705,547 + HK$27,779 − HK$284,258 = HK$1,449,068). As the adjustment will
be applied prospectively to the subsequent five years, depreciation expense equals
(HK$1,449,068/5 years = HK$289,814) and is represented by the following journal entry on
31 December 20Y0:
Debit Credit
HK$ HK$
Depreciation – Right-of-use asset 289,814
Accumulated depreciation – Right-of-use asset 289,814
There is no indication of impairment of the right-of-use asset.
On 1 January 20Y1, Home Supplies recognises the lease payment as follows:
Debit Credit
HK$ HK$
Lease liability 318,000
Cash 318,000
Following this entry, the carrying amount of the lease liability is HK$882,479
(HK$1,200,479 − HK$318,000).
Question 6
The initial measurement of the lease liability is equal to the present value of future lease
payments. The first annual payment of HK$100,000 is not included in this measurement
because it occurred on commencement date (i.e. it is not a ‘future’ lease payment).
Moreover, the variable component of the future annual payments is excluded because
the variable portion is not dependent on an index or a rate but rather on Quality Products’
sales performance.
As Quality Products is reasonably certain it will exercise the option to terminate, the
lease term is only three years. Based on an implicit interest rate of 3% per annum, the
initial measurement of the lease liability is HK$250,831, calculated as follows:
Payment Discount rate Present value
HK$ HK$
1 January 20X8 100,000 1/1.03 97,087
1 January 20X9 100,000 1/1.03 2
94,260
31 December 20X9 50,000 1/1.033 45,757
31 December 20X9 15,000 1/1.033 13,727
Lease Liability as at 1 January 20X7 250,831
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FINANCIAL REPORTING
Question 7
To determine the subsequent measurement of the lease liability, it is first necessary to
determine initial measurement. The present value of future lease payments is as follows:
Payment Discount rate Present value
HK$ HK$
31 December 20X6 25,000 1/1.05 23,810
31 December 20X7 25,000 1/1.05 2
22,676
31 December 20X8 25,000 1/1.05 3
21,596
31 December 20X8 2,500 1/1.053 2,160
Lease Liability 70,242
The amount expected to be payable under the residual value guarantee is the amount
payable by Bambling to ensure Vertical receives HK$7,500 on disposal of the motor
vehicle at the end of the lease term. As Vertical is expected to be able to dispose of the
motor vehicle for HK$5,000 at the end of the lease term, Bambling will be required to pay
Vertical an additional HK$2,500, thereby guaranteeing Vertical receives HK$7,500 as of
31 December 20X8. Accordingly, the lease liability is initially measured at HK$70,242.
Subsequently, the carrying amount of the lease liability will increase due to annual
interest accretion and decrease when the annual lease payments are paid. The carrying
amount of the lease liability at the end of each year following lease commencement is
as follows:
Beginning Payment Interest Ending balance
balance expense (5%) (31/12 each year)
(1/1 each year)
HK$ HK$ HK$ HK$
31 December 20X6 70,242 25,000 3,512 48,754
31 December 20X7 48,754 25,000 2,438 26,192
31 December 20X8 26,192 25,000 1,308a 2,500
a
Balancing item that contains rounding error of HK$2.
To illustrate, at the end of the first year of the lease (31 December 20X6), the lease
payment reduces the lease liability by HK$25,000. However, interest accretion for the
year is HK$3,512 (HK$70,242 × 5%), giving rise to a ‘net’ reduction in the lease liability of
HK$21,488 (HK$25,000 − HK$3,512). This reduces the carrying amount of the lease liability
to HK$48,754 and would be reflected in the following journal entry on 31 December 20X6:
Debit Credit
HK$ HK$
Lease liability 21,488
Interest expense 3,512
Cash 25,000
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Question 8
Answer A is incorrect. The initial measurement of the right-of-use asset ignores the
lease payment made at commencement date, and depreciation is over the lease
term ignoring the tower’s scrap value. Ignoring both items in the initial measurement
of the right-of-use asset and after applying the straight-line basis for depreciation,
depreciation expense for the year ended 31 December 20X5 would equal HK$333,333
(HK$5,000,000/15 years = HK$333,333), giving rise to an incorrect carrying amount of
HK$4,666,667 (HK$5,000,000 − HK$333,333).
Answer B is incorrect. The initial measurement of the right-of-use asset ignores
the lease payment made at commencement date. Ignoring the lease payment at
commencement date in measuring the right-of-use asset, under the straight-line basis
depreciation expense for the year ended 31 December 20X5, would equal HK$174,000
(HK$5,000,000 − HK$650,000/25 years = HK$174,000), giving rise to an incorrect carrying
amount of HK$4,826,000 (HK$5,000,000 − HK$174,000).
Answer C is incorrect. Depreciation has been calculated over the lease term ignoring
the tower’s scrap value. Ignoring the tower’s scrap value in calculating depreciation, and
using the straight-line basis, would give rise to depreciation expense for the year ended
31 December 20X5 equal to HK$363,333 (HK$5,450,000/15 years = HK$363,333) and an
incorrect carrying amount of HK$5,086,667 (HK$5,450,000 − HK$363,333).
Answer D is correct. The initial measurement of the right-of-use asset is equal
to the lease liability plus the lease payment made at commencement date
(i.e. HK$5,000,000 + HK$450,000 = HK$5,450,000). As the lease agreement contains
a purchase option that Clear will probably exercise, the right-of-use asset should be
depreciated until the end of the tower’s useful life (i.e. the depreciation period is 25 years).
Moreover, because Clear is expected to consume the economic benefits of the tower
equally over the tower’s useful life, the straight-line basis of depreciation should be used by
Clear. Using the straight-line basis, depreciation expense for the year ended 31 December
20X5 equals HK$192,000 (HK$5,450,000 − HK$650,000/25 years = HK$192,000), giving rise
to a carrying amount of HK$5,258,000 (HK$5,450,000 − HK$192,000).
Question 9
Looking at the substance of the transaction, the lease should be classified as a finance
lease by Ahoy. Though some factors suggest an operating lease exists (e.g. ownership
does not transfer to TransPacific at the end of the lease term; and the cargo ship is not
custom-designed for TransPacific), the following factors, in combination and on balance,
indicate a finance lease exists:
• TransPacific has an option to purchase the cargo ship at the end of the lease term,
and this option will probably be exercised given the exercise price (HK$500,000)
is substantially lower than the estimated fair value (HK$750,000) of the cargo ship
when the option is exercisable;
• The lease term (30 years) comprises 85.71% of the economic life (35 years) of the
cargo ship, thereby constituting a ‘major part’ of the ship’s economic life; and
• The present value of the lease payments (HK$3,190,179) amounts to 99.7% of the
fair value (HK$3,200,000) of the cargo ship at inception date, thereby representing
substantially all of the cargo ship’s fair value.
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FINANCIAL REPORTING
Question 10
The initial measurement of the net investment in the lease is equal to the present value
of the sum of future lease payments and any unguaranteed residual value accruing to
the lessor. The first annual payment of HK$125,000 is not included in this measurement
because it occurred on commencement date. The fixed portion of the remaining annual
lease payments are included as future lease payments. Moreover, the variable portion
of the remaining annual lease payments is also included because it varies based on the
change in the CPI. As Plus Signs is reasonably certain Prime Success will not terminate
the option, the lease term is four years and the termination penalties are excluded from
the initial measurement of the net investment in the lease. Finally, the entire estimated
residual value of the warehouse of HK$350,000 is included in the initial measurement of
the net investment in the lease because half is guaranteed (and, therefore, falls within the
scope of ‘future lease payments’) and the remaining half is an unguaranteed residual value.
Based on an implicit interest rate of 4% per annum, and a CPI of 100, the initial
measurement of the net investment in the lease is HK$646,069, calculated as follows:
Present value of lease payments
Payment Discount rate Present value
HK$ HK$
1 January 20X7 125,000 1/1.04 120,192
1 January 20X8 125,000 1/1.04 2
115,570
1 January 20X9 125,000 1/1.04 3
111,125
31 December 20X9 175,000 1/1.044 149,591
Present value of lease payments 496,478
Present value of unguaranteed residual value
Payment Discount rate Present value
HK$ HK$
31 December 20X9 175,000 1/1.044 149,591
Present value of unguaranteed 149,591
residual value
Net investment in the lease HK$496, 478 HK$149, 591 HK$646, 069
Question 11
In accordance with HKFRS 15, the transfer of the building is not a sale because TopLine has
retained control of the building. This is indicated by TopLine retaining physical possession
and substantially all the risks and rewards of ownership of the building. As such, the
transaction is accounted for as a financing arrangement in the records of TopLine and
Money Managers as follows.
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TopLine
First, TopLine continues to recognise the equipment at its carrying amount of HK$450,000.
Second, at the commencement date TopLine recognises a financial liability equal to the
transfer proceeds, which equate to the sale proceeds of HK$490,000. The journal entry on
1 January 20X1 would be as follows:
Debit Credit
HK$ HK$
Cash 490,000
Financial liability 490,000
Subsequently, the carrying amount of the financial liability will increase due to annual
interest accretion and decrease when the annual finance payments are paid. The payment
schedule is as follows:
Beginning Payment Interest Ending balance
balance expense (5%) (31/12 each year)
(1/1 each year)
HK$ HK$ HK$ HK$
31 December 20X2 490,000 180,000 24,500 334,500
31 December 20X3 334,500 180,000 16,725 171,225
31 December 20X4 171,225 180,000 8,775 a
0
a
Balancing item that contains rounding error of HK$214.
Using the same payment schedule above, the journal entry that TopLine would record
on 31 December 20X2 would be as follows:
Debit Credit
HK$ HK$
Financial liability 155,500
Interest expense 24,500
Cash 180,000
In addition, the equipment is to be depreciated by TopLine in accordance with HKAS
16. Given that the equipment with a carrying amount of HK$450,000 on 1 January 20X2 is
being depreciated on a straight-line basis over eight years and assuming no indication of
impairment, the journal entry on 31 December 20X2 would be as follows:
Debit Credit
HK$ HK$
Depreciation - Building 56,250
Accumulated depreciation - Building 56,250
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FINANCIAL REPORTING
TopLine would perform the same journal entries on 31 December each year, with
only the apportionment of the HK$180,000 payment between interest expense and
the reduction in the financial liability varying according to TopLine’s payment schedule
previously described.
Money Managers
At the commencement date, Money Managers recognises a financial asset equal to the
transfer proceeds of HK$490,000. The journal entry on 1 January 20X2 would be as follows:
Debit Credit
HK$ HK$
Financial asset 490,000
Cash 490,000
Subsequently, the carrying amount of the financial asset will increase due to finance
income accretion and decrease when the annual finance payments are received. Though
this may not be the case in practice, we assume TopLine and Money Managers make the
same assumptions and estimates so that the carrying amount of the financial asset mirrors
the carrying amount of the financial liability of TopLine.
The journal entry that Money Managers would record on 31 December 20X2 would,
therefore, be as follows:
Debit Credit
HK$ HK$
Cash 180,000
Finance income 24,500
Financial asset 155,500
EXAM PRACTICE
QUESTION 1
Safety First Limited (Safety First) is an airline company that currently operates 20 aircraft to
provide flights to and from all capital cities in Asia. Following an air route feasibility study,
Safety First is seeking to offer flights to and from regional airports in Asia. Air Services
Limited (Air Services) is an aircraft owner with a fleet of aircraft of varying sizes and types.
Safety First enters into a contract with Air Services for the use of 10 of Air Services’ 12 Boeing
767 aircraft. The contract specifies which 10 Boeing 767 aircraft Safety First is to use, with
Air Services required to make the remaining two Boeing 767 aircraft available to Safety First
during periods of repair and maintenance. The contract also states Safety First can decide
which aircraft is to be used for each regional flight.
Under the terms of the contract, Safety First has the exclusive use of the aircraft for
a period of five years, after which time Safety First can extend the contract for five more
years. To encourage Safety First to extend the contract, the contract stipulates that amounts
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Leases
payable by Safety First during the optional period will be recalculated below market rates.
The management of Safety First is uncertain whether it will extend the contract, as it is
too early to forecast the success of the regional air routes. Due to such uncertainty, Safety
First has the option to terminate the contract after three years at a cost of HK$10 million.
The management of Safety First feels the long-term sustainability of the business expansion
can only be determined after four to five years.
Under the terms of the contract, Air Services repairs and maintains the aircraft fleet
and offers pre-and post-flight operations services. Safety First commits to pay Air Services
HK$600 million per annum, payable in arrears, for the use of the aircraft and for the
maintenance and flight operations services. As part of its feasibility study, Safety First
spoke to several of Air Services’ competitors about its planned expansion. Following these
discussions, Safety First can establish that the observable stand-alone price for each Boeing
767 is HK$400,000,000. Safety First is also able to establish observable stand-alone prices for
the maintenance and flight operations services of HK$500,000 per annum and HK$350,000
per annum, respectively.
For the purposes of simplicity, ignore discounting consideration for the time value of money.
(a) Advise Safety First whether the contractual arrangement with Air Services constitutes a
lease and, if so, what the lease term is.
(b) Advise Safety First on how to allocate the total consideration payable between the
different contract components.
QUESTION 2
On 28 December 20X0, Abacus Limited (Abacus) purchases manufacturing equipment
at its fair value of HK$1,150,000. On 1 January 20X1, Proficient Processing Proprietary
Limited (Proficient) enters into an agreement with Abacus for the exclusive use of the new
manufacturing equipment for six years. Before signing the agreement, Proficient hired
local solicitors to review the terms of the agreement. The fee charged by the lawyers is
HK$10,000. Similarly, Abacus incurrs legal fees of HK$46,919 payable only on the agreement
being signed by both parties.
Under the terms of the agreement, Proficient makes all decisions about the use of the
manufacturing equipment during the period of use, including the types and quantities of
products manufactured. Proficient has the option to purchase the equipment after six years
at an exercise price of HK$750,000. The fair value of the equipment at the end of the lease
term is estimated to be HK$1 million. Annual payments are in arrears and equal HK$125,000
plus 2% of Abacus’ last half-yearly sales. As part of this payment, HK$20,000 relates to
annual fees charged by Abacus for maintenance of the equipment. Proficient wishes to
expense the maintenance fees as they are incurred. Proficient guarantees a residual value
of HK$150,000 on the equipment, payable at the end of the six-year period. The interest rate
implicit in the agreement is 3% per annum.
Proficient undertakes alterations totalling HK$100,000 to customise the equipment to
be compatible with Proficient’s production processes. Proficient has an obligation to restore
the equipment to its original state only if it does not exercise the purchase option and it
estimates the restoration will cost HK$50,000. The estimated economic life of the equipment
is eight years, with a scrap value of HK$140,000. Proficient expects to consume the economic
benefits from the equipment evenly.
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FINANCIAL REPORTING
(a) Advise Proficient on the recognition requirements in relation to the agreement
with Abacus.
(b) Describe, with calculations and illustrations by way of journal entries, (i) the initial
measurement of the lease liability and right-of-use asset for Proficient and (ii) the
subsequent measurement of the lease liability and right-of-use asset for proficient for
the first year of the lease term.
(c) Advise Abacus on the classification of the lease as either an operating lease or a
finance lease.
(d) Describe, with illustrations by way of journal entries, the accounting impacts of the
lease for Abacus during the first year of the lease term.
QUESTION 3
High End Furniture Limited (High End) sells a warehouse to Banking and Finance Limited
(Banking) for cash of HK$3.5 million. Immediately before the transfer, the carrying amount of
the warehouse is HK$2 million. The fair value of the warehouse is HK$3 million. Immediately
following the transfer, High End enters into a contract with Banking for the right to use
the warehouse for 10 years. As part of the transaction, High End has transferred physical
possession of the warehouse and all risks and rewards of ownership of the warehouse.
Annual lease payments, payable in arrears, are HK$275,000. The implicit interest rate is 2%
per annum. The present value of the annual payments amounts to HK$2,470,211.
(a) Advise both entities as to whether the transfer of the warehouse constitutes a sale.
(b) Advise High End on how to account for the transfer of the warehouse at the
commencement date of the lease, including the initial journal entry.
(c) Advise Banking on how to account for the transfer of the warehouse at the
commencement date of the lease, including the initial journal entry.
ANSWERS TO EXAM PRACTICE
QUESTION 1
(a) In advising Safety First as to whether the contractual arrangement constitutes a lease,
the flowchart outlined in Section 9.2 (see Exhibit 9.6) is applied. This requires the
following questions to be considered:
Is there an identified asset?
As the contractual arrangement specifies which 10 Boeing 767s Safety First can
use from Air Services’ fleet of 12 Boeing 767s, each of the 10 aircraft constitutes an
identified asset. Air Services’ right to replace any of the ten Boeing 767s with the
remaining two in its fleet only applies during periods of repair and maintenance. This
does not constitute a substantive substitution right preventing Safety First from having
the right to use the identified assets.
Does Safety First have the right to obtain substantially all the economic benefits from use of
the 10 aircraft throughout the period of use?
Because Safety First has the exclusive use of the 10 aircraft for the period specified in
the contract, they obtain substantially all the economic benefits from use of the aircraft
over the contract’s duration.
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Does Safety First, Air Services, or neither party have the right to direct how and why the
10 aircraft are used throughout the period of use?
Only Safety First has the right to direct how and for what purpose the 10 aircraft are
used because the contract enables Safety First to determine which aircraft is to be used
for each flight.
Based on the preceding assessment, the advice to Safety First is that a lease
agreement exists between itself and Air Services.
Having established the existence of a lease, it is now necessary to advise Safety First
on the length of the lease term. The lease term comprises:
• The non-cancellable period of the lease;
• Periods covered by the extension option but only if Safety First is reasonably certain
it will exercise that option; and
• Periods covered by the termination option but only if Safety First is reasonably
certain it will not exercise that option.
In assessing with reasonable certainty whether the extension and/or termination
options will be exercised or not, consideration is given to whether an economic
incentive exists for Safety First to exercise, or not to exercise, the option. This
assessment accounts for all relevant facts and circumstances. Regarding the extension
option, based on weighing up the facts provided, it cannot be concluded with
reasonable certainty that Safety First will exercise the extension option. Though lease
payments during the extended lease period will be below market rates, management
of Safety First is unable to ascertain at the commencement date (per para B37 of
HKFRS 16) of the lease the success of their regional air routes. As such, they cannot be
reasonably certain they will extend the lease beyond the non-cancellable period.
Regarding the termination option, it can be concluded with reasonable certainty
that Safety First will not exercise its termination option for three reasons. First, a
significant termination penalty exists, creating an economic incentive not to terminate.
Second, the termination option becomes exercisable after three years, which
management feels is too early to determine the long-term sustainability of its business
expansion. Finally, the leased aircraft are important to Safety First’s operations because
they are the foundation of its expansion plans and represent one third of all aircraft
used by Safety First.
Overall, Safety First should be advised that the lease term is five years, being the
non-cancellable period of the lease.
(b) As indicated in the preceding information, the lease agreement provides Safety First
with the right to use ten identified assets (i.e. each aircraft is an identified asset). To
advise Safety First on how to allocate total contract consideration between the different
contract components, regard must be given to whether the right to use each aircraft
constitutes a separate lease component.
Based on the facts presented, the right to use each aircraft is a separate lease
component because:
• Safety First can benefit from the use of each aircraft on their own or together with
other resources made readily available to Safety First from Air Services or other
suppliers (e.g. flight crew, catering supplies, flight operations services); and
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• Each aircraft is neither highly dependent on nor highly interrelated with the other
nine aircraft. Safety First’s ability to benefit from the use of an aircraft is neither
dependent on nor interrelated with whether Safety First decides to lease, or not
lease, the other nine aircraft from Air Services.
In addition to providing the use of 10 aircraft, Air Services provides maintenance
and flight operations services to Safety First. The maintenance of each aircraft
constitutes a separate non-lease component, and the flight operations services relate
to the entire fleet and constitutes a single non-lease component. As such, the lease
between Safety First and Air Services contains:
• 10 separate lease components (i.e. the separate rights to use each aircraft); and
• 11 separate non-lease components (i.e. the separate maintenance of ten aircraft,
and overall flight operations services for all regional flight routes).
As part of the advice to Safety First, it must be asked whether Safety First elects
to separate lease and non-lease components when allocating the consideration of
the contract. If yes, the 11 non-lease components are aggregated to form a single
non-lease component meaning that, for accounting purposes, the contract contains
10 lease components and one non-lease component. If no, Safety First accounts for
10 lease components and 11 non-lease components separately. In this case, Safety First
has elected to separate the lease and non-lease components to exclude the non-lease
components forming part of the lease liability and right-of-use asset.
Total contract consideration is HK$3 billion (HK$600 million × 5 years). The total
of the observable stand-alone prices is HK$4,004,250,000 (i.e. (HK$400 million × 10
aircraft) + (HK$500,000 per annum for maintenance × 5 years) + (HK$350,000 per annum
for flight operations services × 5 years)). Safety First will allocate total contract consideration
between the 10 lease components and the aggregated non-lease component as follows:
Component Allocation of contract
consideration
HK$
Aircraft 1 299,681,588a
Aircraft 2 299,681,588
Aircraft 3 299,681,589b
Aircraft 4 299,681,588
Aircraft 5 299,681,588
Aircraft 6 299,681,589b
Aircraft 7 299,681,588
Aircraft 8 299,681,588
Aircraft 9 299,681,589b
Aircraft 10 299,681,588
Non-lease 3,184,117c
Total 3,000,000,000
a
Calculated as HK$400,000,000/HK$4,004,250,000 × HK$3,000,000,000.
b
Rounded up by HK$1 to avoid rounding error in total consideration.
c
Calculated as HK$4,250,000/HK$4,004,250,000 × HK$3,000,000,000.
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QUESTION 2
(a) First, the characteristics of the contract indicate that a lease exists because there is an
identified asset (i.e. manufacturing equipment) that Proficient has a right to control
the use of over a period of time (i.e. Proficient derives substantially all of the economic
benefits from the use of the equipment during the term of the agreement because it
has exclusive use of the equipment and can direct the use of the equipment, including
decisions on the types and quantities of products produced).
Second, the agreement contains a lease (i.e. the use of the equipment) and non-
lease (i.e. the maintenance services provided by Abacus) component. Proficient should
be advised on its right to elect to account for the lease and non-lease component
separately or as a single lease component. If accounting for the lease and non-lease
component separately, Proficient keeps the contract consideration allocated to the
non-lease component off the statement of financial position because it is not included
in the initial measurement of the right-of-use asset and lease liability. Treating the
lease and non-lease component as a single lease component, however, simplifies how
Proficient accounts for the contract because separately accounting for the lease and
non-lease components is unnecessary. Proficient needs to weigh up these factors in
deciding whether to apply the practical expedient of HKFRS 16.15.
Third, the recognition exemptions do not apply as the lease is neither short-term
nor in relation to a low-value underlying asset. The lease term is six years, which
exceeds the 12 months or less maximum to constitute a short-term lease. Moreover,
the manufacturing equipment is not low-value given its fair value when new is
HK$1,150,000.
Based on the preceding information, Proficient is required to recognise a lease
liability and a right-of-use asset for the lease agreement with Abacus.
(b) (i) Initial Measurement
Lease liability
The initial measurement of the lease liability equals the present value of future lease
payments. In calculating the present value of future lease payments, the following is
important:
• The fixed portion of the annual payments relates to the lease and non-lease
components given that HK$20,000 relates to annual fees charged by Abacus
for maintenance of the equipment. As Proficient elects to separate the two
components (to avoid recognising the annual fees as part of the right-of-use asset
and the lease liability), it is only HK$105,000 (HK$125,000 − HK$20,000) per annum
that is treated as a lease payment;
• The variable portion of the annual payments is not a variable lease payment
because the variable portion does not depend on an index or a rate but rather
Proficient’s sales performance;
• As the exercise price of the purchase option (HK$750,000) is expected to be
significantly less than the fair value of the equipment (HK$1 million) at the time the
option is exercisable, Proficient will probably exercise the option to purchase the
equipment. As such, the exercise price of HK$750,000 is included in the calculation
of the lease liability; and
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• Because the fair value of the equipment (HK$1 million) exceeds the amount
guaranteed by Proficient (HK$150,000) at the end of the lease term, the residual
value guarantee is not expected to be payable by Proficient. As such, the residual
value guarantee is not included in the calculation of the lease liability.
Based on the implicit interest rate of 3%, the initial measurement of the lease liability is
HK$1,196,919, calculated as follows:
Payment Discount rate Present value
HK$ HK$
31December 20X1 105,000 1/1.03 101,942
31 December 20X2 105,000 1/1.032 98,973
31 December 20X3 105,000 1/1.033 96,090
31 December 20X4 105,000 1/1.034 93,291
31 December 20X5 105,000 1/1.035
90,574
31 December 20X6 105,000 1/1.036
87,936
31 December 20X6 750,000 1/1.036 628,113
Lease Liability as at 1 January 20X1 1,196,919
Right-of-use asset
Initial measurement of the right-of-use asset includes the lease liability as calculated
immediately above. In addition, the following is important:
• Initial direct costs include the legal fees charged to review the agreement
(HK$10,000); and
• The estimated dismantling costs are not included because Proficient only incurs
this obligation if it does not exercise the purchase option. Because Proficient will
probably exercise the purchase option, the dismantling costs will probably not
be incurred.
In sum, the initial measurement of the right-of-use asset comprises the following:
Cost item Amount
HK$
Lease liability 1,196,919
Initial direct costs 10,000
Right-of-use asset 1,206,919
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The journal entry to record the initial measurement of the lease liability and the
right-of-use asset on 1 January 20X1 is as follows:
Debit Credit
HK$ HK$
Right-of-use asset 1,206,919
Lease liability 1,196,919
Cash 10,000
(b) (ii) Subsequent Measurement
Lease liability
The subsequent measurement of the lease liability will increase due to annual interest
accretion and decrease when the fixed lease payments, the purchase price and the
guaranteed residual value are paid. The carrying amount of the lease liability at the end
of each year following lease commencement is as follows:
Beginning Payment Interest Ending balance
balance expense (3%) (31/12 each year)
(1/1 each year)
31 December 20X1 1,196,919 105,000 35,908 1,127,827
31 December 20X2 1,127,827 105,000 33,835 1,056,662
31 December 20X3 1,056,662 105,000 31,700 983,362
31 December 20X4 983,362 105,000 29,501 907,863
31 December 20X5 907,863 105,000 27,236 830,099
31 December 20X6 830,099 105,000 24,901a 750,000
a
Balancing item that contains rounding errors of HK$2.
As evident from the above table, the carrying amount of the lease liability on
31 December 20X1 is HK$1,127,827.
The journal entry to account for the first annual payment on 31 December 20X1
would be as follows:
Debit Credit
HK$ HK$
Lease liability 69,092
Interest expense 35,908
Maintenance services expense 20,000
Cash 125,000
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Right-of-use asset
The subsequent measurement of the right-of-use asset is net of accumulated depreciation
and any accumulated impairment loss. Regarding depreciation, because Proficient will
probably exercise the option to purchase the equipment at the end of the lease term,
depreciation should be over the equipment’s useful life (i.e. eight years). As Proficient
expects to consume the economic benefits from the equipment evenly, depreciation
is calculated on a straight-line basis. As such, depreciation expense equals HK$133,365
((HK$1,206,919–HK$140,000)/8 years). Assume the right-of-use asset is not impaired.
As at 31 December 20X1, the carrying amount of the right-of-use asset would equal
HK$1,073,554 (HK$1,206,919 − HK$133,365).
The journal entry to account for the subsequent measurement of the right-of-use
asset on 31 December 20X1 would be as follows:
Debit Credit
HK$ HK$
Depreciation – Right-of-use asset 133,365
Accumulated depreciation – Right-of-use asset 133,365
Assuming the right-of-use asset is not impaired, no journal entry is necessary to
account for impairment.
(c) Looking at the substance of the transaction, the lease should be classified as a finance
lease by Abacus because the lease transfers substantially all the risks and rewards
incidental to ownership of the equipment to Proficient. Even though the equipment is
not custom-designed for Proficient, which is an indicator an operating lease exists, the
following facts, in combination, indicate a finance lease exists:
• Proficient has an option to purchase the equipment at the end of the lease term,
and this option will probably be exercised given the exercise price (HK$750,000) is
substantially lower than the estimated fair value (HK$1 million) of the equipment
when the option is exercisable;
• The lease term (six years) comprises 75% of the economic life (eight years) of the
equipment, thereby constituting a ‘major part’ of the equipment’s economic life; and
• The present value of the lease payments (HK$1,196,919) exceeds the fair value
(HK$1,150,000) of the equipment at inception date, thereby representing all of the
equipment’s fair value.
(d) Prior to preparation of the journal entries to account for the finance lease, it is
necessary to determine whether Abacus is a financier lessor or a manufacturer or
dealer lessor. As Abacus acquired the equipment at fair value and soon after leased it
to Proficient, the acquisition of the equipment was to lease it to Proficient. Abacus
neither leases out equipment it manufactured nor was Abacus a dealer in
manufacturing equipment that it normally acquires for resale; instead, it chose to lease
the equipment to Proficient. As such, Abacus is a financier lessor. Unlike Proficient, the
practical expedient of treating the lease and non-lease component as a single lease
component is not available to Abacus. As such, Abacus must account for the lease
(i.e. the use of the equipment) and non-lease (i.e. the maintenance services provided by
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HKFRS
Abacus) components separately, and allocate the consideration between the lease and
16.17 non-lease components by applying paras 73–90 of HKFRS 15.
See Chapter 5, Section 5.2.4 (Allocating the Transaction Price to Performance
Obligations – Step 4) for further discussion of the HKFRS 15 requirements for allocating
consideration across lease and non-lease components.
Initial measurement
Because the lease is a finance lease, Abacus must undertake the following at the
commencement date of the lease: derecognise the manufacturing equipment as an asset;
and recognise a lease receivable as an asset equal to the net investment in the lease.
The derecognition of the manufacturing equipment will be at an amount equal to its
carrying amount (HK$1,150,000). As there is no unguaranteed residual value accruing to
Abacus, the net investment in the lease is measured at an amount that equals the lease
liability initially recognised by Proficient (i.e. the present value of future lease payments,
which equals HK$1,196,919). The implicit interest rate of 3% ensures the net investment
in the lease is equal to the fair value of the underlying asset plus initial direct costs of
the lessor (i.e. HK$1,150,000 + HK$46,919 = HK$1,196,919).
The following journal entry would be prepared on 1 January 20X1 to derecognise
the equipment and recognise the lease receivable:
Debit Credit
HK$ HK$
Lease receivable 1,196,919
Equipment 1,150,000
Cash 46,919
Subsequent measurement
After lease commencement, Abacus recognises finance income over the lease term
by allocating the lease payments receivable between finance income to Abacus and
the repayment of the lease receivable (i.e. the net investment in the lease) using the
interest rate implicit in the lease. Because the net investment in the lease initially
recognised by Abacus equates to the lease liability initially recognised by Proficient,
the carrying amount of the lease receivable at the end of each year corresponds with
the carrying amount of the lease liability over the lease term. That is:
Beginning Receipt Finance Ending balance
balance income (3%) (31/12 each year)
(1/1 each year)
HK$ HK$ HK$ HK$
31 December 20X1 1,196,919 105,000 35,908 1,127,827
31 December 20X2 1,127,827 105,000 33,835 1,056,662
31 December 20X3 1,056,662 105,000 31,700 983,362
31 December 20X4 983,362 105,000 29,501 907,863
31 December 20X5 907,863 105,000 27,236 830,099
31 December 20X6 830,099 105,000 24,901 750,000
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The journal entry to account for the first annual payment received on 31 December
20X1 would be as follows:
Debit Credit
HK$ HK$
Cash 125,000
Finance income 35,908
Maintenance services income 20,000
Lease receivable 69,092
Assuming the net investment in the lease is not impaired, no journal entry is
necessary to account for impairment.
QUESTION 3
(a) In advising each contracting party as to whether the transfer constitutes a sale, it must
be determined whether control of the asset has transferred to Banking, and it must be
established whether and when High End satisfies a performance obligation, thereby
transferring control of the asset.
Based on the facts, High End satisfies a performance obligation, thereby
transferring control of the warehouse to Banking, at the time of the transfer. Banking
has the ability to direct the use of, and obtain substantially all of the remaining benefits
from, the warehouse as High End has transferred physical possession and substantially
all the risks and rewards of ownership of the warehouse. Through physical possession
and having the risks and rewards of ownership, Banking can determine how the
warehouse is to be used and can prevent other entities from directing the use of, and
obtaining the benefits from, the warehouse. As such, the transfer constitutes a sale.
(b) Because the transfer is a sale, at the commencement date, High End accounts for the
sale as follows:
• Recognises the sale proceeds as an increase in cash at bank or receivables;
• Derecognises the warehouse as an asset;
• Recognises a right-of-use asset arising from the leaseback;
• Recognises a gain or loss on the rights transferred to Banking; and
• Recognises a financial liability comprising a lease liability and a liability due to
additional financing provided by Banking.
Based on the facts, the sale was not on market terms. This is because the sale
proceeds (HK$3.5 million) are significantly above the fair value (HK$3 million) of the
warehouse at the time of the sale. An adjustment is made so the excess sale price
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(HK$500,000) is recognised as additional financing provided by Banking to High End. As
such, the present value of the annual payments (HK$2,470,211) comprises two parts:
1. HK$500,000 relates to annual payments for the additional financing provided by
Banking; and
2. HK$1,970,211 (HK$2,470,211 − HK$500,000) relates to annual payments for the
lease of the warehouse.
At the commencement date, High End measures the right-of-use asset as a
proportion of the carrying amount of the derecognised warehouse that relates to the
rights retained to continue to use the warehouse. This is calculated as follows:
HK$2, 000, 000
HK$1, 970, 211 HK$1, 313, 474
HK$3, 000, 000
Alternatively, the calculation could be expressed as follows:
HK$1, 970, 211
HK$2, 000, 000 HK$1, 313, 474
HK$3, 000, 000
Though the overall gain on sale of the warehouse totals HK$1,000,000
(HK$3,000,000 − HK$2,000,000), the gain that relates to the rights transferred to
Banking is calculated as follows:
HK$1, 000, 000
(HK$3, 000, 000 HK$1, 970, 211) HK$343, 263
HK$3, 000, 000
Based on the preceding information, High End will account for the sale and
leaseback transaction at the commencement date as follows:
Debit Credit
HK$ HK$
Cash 3,500,000
Right-of-use asset 1,313,474
Warehouse 2,000,000
Gain on rights transferred 343,263
Financial liability 2,470,211
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FINANCIAL REPORTING
(c) In advising Banking, consideration must first be given to whether the lease is an
operating lease or a finance lease. As control of the warehouse has been transferred to
Banking, including substantially all risks and rewards of ownership, Banking would treat
the lease as an operating lease.
Banking would recognise the purchase of the warehouse, along with the
additional financing it provides High End, with the following journal entry at the
commencement date:
Debit Credit
HK$ HK$
Warehouse 3,000,000
Financial asset 500,000
Cash 3,500,000
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10
Borrowing Costs
CHAPTER TOPIC LIST
10.1 Overview 10.2.2 Specific Borrowings
10.1.1 Scope 10.2.3 General Borrowings
10.1.2 Terminology 10.2.4 Capitalisation
10.2 Recognition 10.3 Disclosure
10.2.1 Borrowing Costs Eligible
for Capitalisation
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FINANCIAL REPORTING
LEARNING OUTCOMES
PRINCIPAL LO2: APPLY APPROPRIATE ACCOUNTING PRINCIPLES AND CONCEPTS TO ACCOUNT
FOR BUSINESS TRANSACTIONS
LO2.04: D
escribe and account for business transactions in accordance with Hong Kong Financial
Reporting Standards as they relate to Borrowing Costs
2.04.01 Explain the expenses that constitute borrowing costs
2.04.02 Explain borrowing costs eligible for capitalisation
2.04.03 Explain the assets that are qualifying assets
2.04.04 Explain when the capitalisation of borrowing costs shall commence, be suspended and cease
2.04.05 Calculate the amount of borrowing costs in respect of specific borrowing and general
borrowing to be capitalised
2.04.06 Prepare journal entries for borrowing costs, including expensed and capitalised
borrowing costs
2.04.07 Prepare disclosure in respect of borrowing costs
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B orro w ing C osts
OPENING CASE
BEYOND ENTERTAINMENT GROUP
B eyond Entertainment Group (BEG) is a theme park and entertainment company, owning
and operating leisure assets primarily in Hong Kong and mainland China, but has in recent
years, begun to extend its operations by developing sites in South East Asia.
BEG began in 2002 with a site in Beijing, which it built from the ground up. BEG’s expansion
began in 2008 when it began to acquire and revamp additional sites throughout the mainland,
particularly in Shanghai, Guangzhou and Chengdu.
BEG’s portfolio of assets primarily focuses on theme parks, with FunCity being its core
brand. FunCity sites are large-scale, open air sites, with a variety of rides and other attractions
at each. It also has a range of indoor entertainment sites though its DigitalCity brand. These are
smaller scale operations, primarily housed in shopping malls. DigitalCity’s focus is on immersive
video game experiences.
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OVERVIEW
Accounting for borrowing costs may, at first, appear to be relatively straightforward. Users can
see an expense line in profit or loss, so it would seem obvious that whatever borrowing costs
an entity has would end up being recognised there. However, when you also consider that
cost for most assets includes any costs directly attributable to making the asset ready for its
intended use and when you also take into account that borrowing to finance the acquisition or
construction of many assets is required, the situation becomes less straightforward.
But how does this determination of whether a borrowing cost is capitalised or an expense
occur? Consider the case of BEG, which has expanded substantially in recent years. Some of
this expansion has taken place through the acquisition of rival sites, and some has taken place
through the construction and development of new sites. The time taken to acquire or construct
the site and the way in which the borrowing was arranged are major factors that will influence
whether the borrowing costs are capitalised or expensed.
This chapter focuses on the recognition of borrowing costs. You should gain an
understanding of the types of assets entities are required to capitalise borrowing cost against,
when these borrowing costs can be capitalised as opposed to expensed and how to prepare
the journal entries required for borrowing costs. At the end of this chapter, you should also
prepare the disclosures an entity needs to make about its borrowing costs to help users of
its financial statements understand how it has arrived at the recognised asset figures on the
statement of financial position.
1 0 . 1 OVERVIEW
This chapter addresses the accounting for borrowing costs in accordance with HKAS 23
Borrowing Costs. The core principle of HKAS 23 is that borrowing costs that are directly
HKAS attributable to the acquisition, construction or production of a qualifying asset form part of the
23.1 costs of that asset. Other borrowing costs are recognised as an expense.
The principal issues in accounting for borrowing costs are:
• to identify which borrowing costs are eligible for capitalisation; and
• to determine when the capitalisation of borrowing costs is to occur.
In this section, you will gain an understanding of the borrowing costs to which HKAS 23
applies and will be introduced to some of the terminology relevant to applying the principles
in HKAS 23.
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10.1.1 Scope
Entities can obtain funds from a variety of external sources, but ultimately the sources of
these funds are equity holders (i.e. shareholders) or debt holders (i.e. banks, bondholders,
etc.). HKAS 23 applies to accounting for essentially all borrowing costs in relation to debt. This
could include the costs in relation to a bank loan, an overdraft or public debt such as a bond
issue. The cost of equity, whether actual or imputed (i.e. opportunity cost) is not within the
scope of HKAS 23. For example, if BEG (from the opening case) was to borrow funds to build
a new rollercoaster (assuming it is a qualifying asset), the cost of these funds would be within
the scope of HKAS 23. However, if BEG were to issue new shares to the market to raise funds
to build the rollercoaster, the cost relating to the shares would not be within the scope of
the standard.
In addition, an entity is not required to apply HKAS 23 to borrowing costs directly
attributable to the acquisition, construction or production of:
• a qualifying asset measured at fair value; or
HKAS • inventories that are manufactured, or otherwise produced, in large quantities on a
23.4 repetitive basis.
The International Accounting Standards Board (IASB) in its deliberations on IAS 23
(equivalent to HKAS 23) decided that any requirements on how to account for borrowing cost
for assets measured at fair value would be unnecessary as the measurement of these assets
would not be affected by any borrowing costs incurred during their construction or production
period. In relation to inventories manufactured in large quantities on a repetitive basis, the
IASB decided not to require entities to capitalise borrowing costs for these assets as there
would be a significant administrative burden placed on the entity and, accordingly, the costs of
capitalisation were likely to outweigh any benefits.
10.1.2 Terminology
HKAS HKAS 23 defines borrowing costs as interest and other costs that an entity incurs in connection
23.5 with the borrowing of funds. Borrowing costs may include:
• interest expense calculated using the effective interest method;
• interest in respect of lease liabilities recognised in accordance with HKFRS 16
Leases; and
HKAS • exchange differences arising from foreign currency borrowings to the extent that they
23.6 are recognised as an adjustment to interest costs.
A qualifying asset is an asset that necessarily takes a substantial period of time to get
ready for its intended use or sale. For example, if BEG were to spend 18 months building
a new rollercoaster, this would more than likely be a qualifying asset. Depending on the
circumstances, any of the following may be qualifying assets:
• inventories
• manufacturing plants
• power generation facilities
• intangible assets
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FINANCIAL REPORTING
• investment properties
• bearer plants
Financial assets and inventories that are manufactured or otherwise produced, over a short
HKAS period of time, are not qualifying assets. Assets that are ready for their intended use or sale
23.7 when acquired are not qualifying assets. For example, the purchase of an already completed
merry-go-round that is ready for use would not be a qualifying asset.
1 0 . 2 RECOGNITION
Entities will often need to borrow funds to undertake activities, such as the purchase of
inventory, acquisition of machinery or the construction of buildings. Whether entities are
required to capitalise or expense the cost related to the borrowed funds is determined by the
relationship between the funds borrowed and the nature of the asset itself. When the
borrowing costs are directly attributable to the acquisition, construction or production of a
qualifying asset, the entity is required to capitalise the costs as part of that asset cost.
HKAS Otherwise, the entity recognises the borrowing costs as an expense in the period in which the
23.8 entity incurs them.
The underlying rationale for the inclusion of directly attributable borrowing costs as part of
the asset cost is that the expenditures required for the development of an asset must be
financed, and this financing has a cost. As the cost of the asset should include all costs
IAS necessarily incurred to get the asset ready for its intended use or sale, the costs of finance
23.BC9 should also be included in the cost of the asset.
10.2.1 Borrowing Costs Eligible for Capitalisation
The borrowing costs directly attributable to the acquisition, construction or production of a
HKAS qualifying asset are those borrowing costs that would have been avoided if the expenditure on
23.10 the qualifying asset had not been made.
This is relatively straightforward to determine when the entity borrows funds specifically
for the purpose of obtaining a particular qualifying asset. However, determining the borrowing
costs to be allocated to a qualifying asset is more difficult when the entity centrally coordinates
its financing activity. For example, companies may issue bonds to help finance their operations.
These issues are not necessarily linked to the acquisition of a specific qualifying asset but for the
entity more broadly. Section 10.2.2 will cover how an entity recognises borrowing costs when the
entity borrows funds for a specific qualifying asset, and Section 10.2.3 will cover how an entity
recognises borrowing costs for a qualifying asset when the entity borrows funds generally.
10.2.2 Specific Borrowings
When the entity has borrowed specifically to fund the acquisition of a qualifying asset, the
borrowing costs for the purposes of the standard are the actual borrowing costs incurred on
HKAS that borrowing during the period less any investment income on the temporary investments of
23.12 those borrowings. For example, when BEG borrows funds at 5% to acquire a qualifying asset
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and the total cost of the borrowing for the period is HK$250,000, that HK$250,000 is the
borrowing cost for the purpose of HKAS 23.
The entity will likely obtain the borrowed funds in advance of needing to use them for
expenditures on the qualifying asset. In those cases, the funds will often be temporarily
invested until they can be used on the qualifying asset in question. Any investment income
earned on those funds will be netted off against the borrowing costs eligible for capitalisation.
10.2.3 General Borrowings
Some entities will need to borrow specifically for a project. They may have existing borrowed
funds to draw on to be able to acquire, construct or produce a qualifying asset. For example,
assume BEG has the following existing borrowing at the start of the year:
• HK$100 million at 6.25%
• HK$50 million at 5.75%
• HK$70 million at 6.10%
In this case, if BEG were to construct a new gaming centre on land it currently owns
with some of these pre-existing borrowed funds, it would be impossible to identify which of
the borrowings and, therefore, the rate used for the acquisition. As such, HKAS 23 requires
that BEG determines the amount of borrowing costs eligible for capitalisation by applying a
capitalisation rate to the expenditures on the asset acquired.
To determine the capitalisation rate, the entity first excludes any borrowings made by the
entity specifically for the purpose of obtaining a qualifying asset. Once that is done, a weighted
average of the borrowing costs applicable to the borrowings of the entity (outstanding during
the period) is calculated. Using the BEG example, the capitalisation rate would be calculated as
in the following table (Exhibit 10.1).
Interest Borrowing Calculation Weighted
rate HK$ million average rate
6.25% 100 6.25% × 100/220 2.84%
5.75% 50 5.75% × 50/220 1.31%
6.10% 70 6.10% × 70/220 1.94%
Total 220 6.09%
EXHIBIT 10.1 Calculation of capitalisation rate applicable to BEG’s general borrowings
Borrowing costs applicable to borrowings made specifically for the purpose of obtaining a
qualifying asset are excluded from the calculation of general borrowings until substantially all
the activities necessary to prepare that asset for its intended use or sale are complete. The
HKAS amount of borrowing costs that an entity capitalises during a period cannot exceed the amount
23.14 of borrowing costs it incurred during that period.
10.2.4 Capitalisation
As noted in Sections 10.2.1–10.2.3, an entity shall capitalise borrowing costs directly attributable
to the acquisition, construction or production of a qualifying asset. What we now turn to is
when an entity can commence capitalising borrowing costs, when it is required to suspend
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capitalising borrowing costs and when it must cease capitalising borrowing costs. These are all
covered in the remainder of Section 10.2.4.
10.2.4.1 Commencement
An entity shall commence capitalising borrowing costs as part of the cost of a qualifying asset
HKAS on the commencement date. The commencement date for capitalisation is the date when the
23.17 entity first meets all of the following conditions:
• It incurs expenditures for the asset. These only include expenditures that have resulted
in the payment of cash, transfers of other assets or the assumption of interest bearing
liabilities;
• It incurs borrowing costs; and
• It undertakes activities necessary to prepare the asset for its intended use or sale. Activities
do not just mean the physical construction of the asset. They can include the technical and
administrative work prior to the physical construction (i.e. seeking development permits
or approvals). However, simply holding the asset when no production or development is
taking place that changes the asset’s condition, for example, land-banking, is not an activity
for the purposes of determining the commencement date.
10.2.4.2 Suspension
Because an entity can commence capitalising borrowing costs may not mean it will be able to
continue capitalising borrowing costs until the qualifying asset is ready for its intended use or
sale. Depending on the circumstances, an entity may be required to suspend the capitalisation
HKAS of borrowing costs. This will occur during extended periods in which an entity suspends active
23.20 development of a qualifying asset. For example, an entity may suspend active development of a
qualifying asset while it is waiting for a specific component part to arrive from overseas if this
waiting period could have been avoided had proper planning occurred.
Judgement will be required to determine whether the capitalisation of borrowing costs is to
be suspended as this must occur when active development of a qualifying asset is suspended
for an extended period. This would be so even if there was substantial administrative or
technical work being carried out. However, temporary delays that are a necessary part of the
process to prepare an asset for its intended use or sale, for example, due to high water levels
HKAS during the construction of a bridge, would not be viewed as an extended period and thus not
23.21 require a suspension of the capitalisation of borrowing costs.
10.2.4.3 Cessation
HKAS Once an entity has substantially completed all the activities necessary to prepare the qualifying
23.22 asset for its intended use or sale, it is required to cease capitalising borrowing costs. This will
normally occur when the physical construction of the asset has been completed even if routine
administrative work or minor modifications still need to be finalised.
In some cases, an entity will complete the construction of a qualifying asset in parts. If a
completed part is capable of being used while construction is continuing on other parts, the
HKAS entity shall cease capitalising borrowing costs when it completes substantially all the activities
23.24 necessary to prepare that part for its intended use or sale. An example of this is a university
constructing a new campus constituting a number of different buildings. If, as a building is
completed, staff or students can use it, the capitalisation of borrowing costs related to the
completed building will cease and the capitalisation of borrowing costs for the buildings still to
be completed will continue.
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Apply and Analyse 1
BEG has decided to take advantage of the growing popularity of virtual reality (VR) gaming
to redevelop an existing DigitalCity site in Hong Kong. The redevelopment is expected to
take 18 months, and once complete, the site will be a fully equipped VR gaming complex.
BEG has signed a HK$40 million contract with Advanced Gaming Systems Limited (AGS) to
complete the development.
The terms of the contract are that BEG will pay AGS the following:
• 10% on signing the contract
• 30% in six months
• 40% on delivery
• 20% three months after delivery
The contract was signed on 1 September 20X6, work began immediately, and the
redevelopment was completed on 28 February 20X8 as expected.
Because of the nature of the development, BEG had to borrow funds specifically for
the project. It was able to borrow HK$40 million from Metropolitan Bank on 1 September
20X6. The interest-only loan had a three-year term with a fixed rate of interest of 5.75%
per annum paid annually. As not all the funds were required immediately, BEG placed the
surplus funds in an investment account with Metropolitan Bank earning 4.75% per annum
until they were required.
Calculate the borrowing costs capitalised against the BEG development, and prepare
the journal entry for the borrowing costs as at 30 June 20X7.
Analysis
The first step is to determine whether the BEG site redevelopment is a qualifying asset. A
qualifying asset is one that necessarily takes a substantial period of time to get ready for its
intended use or sale. In this case, the redevelopment takes 18 months (1 September 20X6
through to 28 February 20X8) to completely construct and make ready for use. Though
substantial period of time is not defined in the standard, we can assume that 18 months is
a substantial period of time, and therefore, the site redevelopment is a qualifying asset.
This means that borrowing costs directly attributable to the acquisition, construction or
production of a qualifying asset are included as part of the asset cost.
BEG can only begin capitalising borrowing cost when all of the following three
conditions are met: (1) BEG has incurred expenditures for the asset; (2) BEG incurs
borrowing costs; and (3) BEG is undertaking activities necessary to prepare the development
for its intended use. As the borrowing, work and initial payment for the development all
occurred on 1 September 20X6, this is the date on which capitalisation can begin.
Because the funds were borrowed specifically for the redevelopment, the amount of
borrowing costs eligible for BEG to capitalise are the actual borrowing cost incurred on that
borrowing during the period less any investment income on the temporary investment of
those borrowings.
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Apply and Analyse 1 (continued)
Period Calculation Amount
(HK$)
Actual borrowing costs 1 September 20X6 HK$40,000,000 1,916,667
– 30 June 20X7 × 5.75% × 10/12
less: Investment income 1 September 20X6 HK$36,000,000 (855,000)
– 28 February 20X7 × 4.75% × 6/12
less: Investment income 1 March 20X7 – 30 June 20X7 HK$24,000,000 (380,000)
× 4.75% × 4/12
Eligible borrowing costs 681,667
Thus, the total borrowing costs eligible to be capitalised against the BEG
redevelopment as of 30 June 20X7 is HK$681,667.
Entry as at 30 June 20X7
Debit Credit
HK$ HK$
Property, plant and equipment 681,667
Cash 681,667
(Recognition of borrowing costs)
Apply and Analyse 2
As BEG was in the process of the redeveloping the DigitalCity site in Hong Kong, it decided
to upgrade one of the main rollercoasters at their Guangzhou site. The contract for the
project was signed on 1 December 20X6, and work began on 1 March 20X7. The project
will cost HK$90 million and is expected to take two years to complete. HK$10 million
is paid upon work beginning, and HK$20 million is paid every six months beginning on
1 September 20X7 until project completion.
BEG did not borrow funds specifically for the rollercoaster. In addition to the funds
borrowed for the DigitalCity site redevelopment, BEG had the following funds outstanding
on 1 December 20X6:
• 6.25% ten-year note with interest paid annually; HK$100 million with this amount
remaining unchanged through to 30 June 20X7.
• 5.75% five-year note with interest paid annually; HK$50 million with this amount
remaining unchanged through to 30 June 20X7.
• 6.10% five-year note with interest paid annually; HK$70 million with this amount
remaining unchanged through to 30 June 20X7.
Calculate the borrowing costs capitalised against the rollercoaster and prepare the
journal entry for the borrowing costs as at 30 June 20X7.
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Apply and Analyse 2 (continued)
Analysis
The total borrowing cost for the general borrowings for the period ended 30 June 20X7 is
HK$13,395,000 (calculated as HK$100 million × 6.25% + HK$50 million × 5.75% + HK$70
million × 6.10%). However, not all borrowing costs can be capitalised. To work this out, a
number of steps are required.
The first step is to determine whether the rollercoaster is a qualifying asset. A qualifying
asset takes a substantial period of time to get ready for its intended use or sale. In this case,
the rollercoaster is expected to take two years to construct and make ready for use. Though
a substantial period of time is not defined in the standard, we can assume two years is a
substantial period of time, and therefore, the rollercoaster is a qualifying asset. This means
that borrowing costs directly attributable to the acquisition, construction or production of a
qualifying asset are included as part of the cost of that asset.
The second step is to determine when BEG can begin capitalising the borrowing costs.
As noted previously, this occurs when all of the following three conditions are met: (1) BEG
incurs expenditures for the construction of the rollercoaster; (2) BEG incurs borrowing
costs; and (3) BEG undertakes activities necessary to prepare the rollercoaster for its
intended use. The first date for all of these conditions to be met is 1 March 20X7.
The third step is to determine the amount of borrowing costs to be capitalised
against the rollercoaster. In this case, no funds have been borrowed specifically for the
construction of the rollercoaster. As such, BEG needs to multiply the capitalisation rate
to the expenditures made during the period. The capitalisation rate is calculated as
the weighted average of the borrowing cost applicable to the borrowings of the entity
outstanding during the period other than borrowings made specifically for the purpose of
obtaining a qualifying asset. During the period ended 30 June 20X7, BEG had four separate
borrowings, three notes, and a HK$40 million loan from Metropolitan Bank. As the loan
had been borrowed for the purpose of the redevelopment, the capitalisation rate was the
weighted average of the borrowing cost of the notes, which in this case, was 6.09% per
annum (calculated as 6.25% × HK$100 million/HK$220 million + 5.75% × HK$50 million/
HK$220 million + 6.10% × HK$70 million/HK$220 million).
Between the commencement date and 30 June 20X7, the only expenditure made on
the rollercoaster was the HK$10 million payment made on the commencement date. As
such, the total borrowing costs for the period ended 30 June 20X7 (HK$13,395,000) that can
be capitalised were HK$203,000 (calculated as HK$10 million × 4/12 × 6.09%).
Entry as at 30 June 20X7
Debit Credit
HK$ HK$
Rollercoaster 203,000
Interest expense 13,192,000
Cash 13,395,000
(Recognition of borrowing costs)
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Illustrative Example 1
City Machinery borrows AUD two million from Oz Bank on 1 July 20X7 to construct a
small manufacturing plant. Construction is expected to take two years. Construction
began on 1 July 20X7, with the first payment of HK$1 million taking place at that time.
By 30 June 20X8, a total of HK$6 million had been incurred in construction expenditure.
Total construction costs are expected to total approximately HK$11 million.
The loan is interest-only, and semi-annual interest payments are in arrears at a rate of
7% per annum.
The following exchange rates are applicable:
1 July 20X7 HK$1 = AUD0.18
Average July – December 20X7 HK$1 = AUD0.20
31 December 20X7 HK$1 = AUD0.23
City Machinery is required to make an interest payment of AUD 70,000 on 31 December 20X7 to Oz
Bank. At the prevailing rate of HK$1 = AUD0.23, this means a total of HK$304,348 (AUD 70,000/0.23)
is paid. The capitalisation of the interest costs for the period comprise the interest expense of
HK$350,000 (AUD 70,000/0.20) and the foreign exchange gain of HK$45,652 (AUD70,000/0.20 −
AUD70,000/0.23).
HKAS
Borrowing costs include exchange differences arising from foreign currency borrowings to
23.6 the extent they are recognised as an adjustment to interest costs. As such, the journal
entry of City Machinery to record the interest cost on the borrowings on 31 December
20X7 is as follows:
Entry as at 31 December 20X7
Debit Credit
HK$ HK$
Machinery 304,348
Cash 304,348
(Recognition of borrowing costs including exchange difference)
Knowledge Check Questions
Question 1
HRC borrows HK$22 million to purchase and install a wind turbine. The funds were
borrowed on 1 December 20X4, the full payment for the wind turbine of HK$22 million
was made on 1 January 20X5 and construction began on 1 January 20X5. Construction is
expected to take 15 months. The interest rate on the loan was 5.5% per annum. Assume
the wind turbine meets the definition of a qualifying asset.
For the year ended 31 March 20X5, prepare journal entries for the borrowing costs,
including expensed and capitalised borrowing costs.
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Knowledge Check Questions (continued)
Question 2
ABB builds a bridge for HK$35 million, with construction beginning on 1 January 20X6.
Half of the cost of bridge construction was paid at the time construction began. ABB’s
borrowings as at 31 March 20X6 were as follows:
• 5.5% five-year note with interest paid annually; the debt outstanding at 31 March
20X6 was HK$60 million and remained unchanged during the year.
• 4.75% five-year note with interest paid annually; the debt outstanding at 31 March
20X6 was HK$40 million and remained unchanged during the year.
No borrowings had been used for specific projects, and you can assume the bridge
meets the definition of a qualifying asset. Assume there were no other transactions
during the year.
For the year ended 31 March 20X6, prepare journal entries for the borrowing costs,
including expensed and capitalised borrowing costs.
1 0 . 3 DISCLOSURE
The disclosure requirements for borrowing costs are relatively limited in nature. The
requirements in HKAS 23.26 are simply that an entity disclose:
• the amount of borrowing costs capitalised during the period; and
• the capitalisation rate used to determine the amount of borrowing costs eligible for
capitalisation.
For example, BEG may disclose the information in Exhibit 10.2 to comply with these
requirements.
Note X: Finance costs
20X7 20X6
HK$’000 HK$’000
Interest expenses on bank and other borrowings 15,312 13,395
less: Amount capitalised to DigitalCity redevelopment (682) 0
less: Amount capitalised to Rollercoaster (203) 0
14,427 13,395
During the year ended 30 June 20X7, BEG capitalised interest expenses of HK$884,667. HK$40 million
were borrowed specifically in relation to the DigitalCity redevelopment. The remainder of the borrowing
costs capitalised were in relation to the construction of a new rollercoaster at Guangzhou. A capitalisation
rate of 6.09% per annum was used in this case.
EXHIBIT 10.2 Illustrative disclosure
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SUMMARY
• HKAS 23 specifies the accounting for borrowing costs.
• Borrowing costs directly attributable to the acquisition, construction or production of a
qualifying asset form part of that asset cost. Other borrowing costs are recognised as
an expense.
• If the borrowing costs have been incurred in relation to a specific qualifying asset, the
borrowing costs eligible for capitalisation are the actual borrowing costs incurred less any
investment income on the temporary investment of those borrowings.
• If an entity borrows funds generally and uses a portion of them to obtain a qualifying
asset, the entity shall determine the borrowing costs eligible for capitalisation by applying a
capitalisation rate to the expenditures on the asset.
• Capitalisation of borrowing costs shall begin when the entity meets all three of the
following criteria:
1. It incurs expenditures for the asset;
2. It incurs borrowing costs; and
3. It undertakes activities necessary to prepare the asset for its intended use or sale.
• Capitalisation of borrowing costs shall be suspended when the entity suspends the active
development of a qualifying asset for an extended period.
• Capitalisation of borrowing costs shall cease when substantially all the activities necessary to
prepare the qualifying asset for its intended use or sale are complete.
• If a qualifying asset is comprised of parts that are completed separately and are capable of
being used while construction is continuing, borrowing cost capitalisation shall cease once
substantially all the activities necessary to prepare that part for its intended use or sale have
been completed.
• Entities are required to disclose the amount of borrowing costs capitalised during the period
as well as the capitalisation rate used.
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MIND MAP
SCOPE DEFINITIONS
Inclusions Borrowing costs are interest and other
• Borrowing costs costs that an entity incurs in connection
Exclusions with the borrowing of funds
• Qualifying assets at fair value Qualifying assets are assets that necessarily
• Inventories that are manufactured in large take a substantial period of time to get
quantities on a repetitive basis ready for their intended use or sale
DISCLOSURE BORROWING COMMENCEMENT OF CAPITALISATION
CASTS
Amount of borrowing costs capitalised (HKAS 23) Capitalisation commences when all three
during the period of the following have been met by the entity
Capitalisation rate used to determine • It incurs expenditures for the asset;
borrowing costs eligible for capitalisation • It incurs borrowing costs; and
• It undertakes activities that are necessary
CESSATION OF CAPITALISATION to prepare the asset for its intended use
Capitalisation will cease when substantially or sale
all the activities necessary to prepare the SUSPENSION OF CAPITALISATION
asset for use or sale have been completed
Capitalisation is suspended when the entity
RECOGNITION suspends active development of the asset
An entity shall capitalise borrowing costs that are directly for an extended period
attributable to the acquisition, construction or production
of a qualifying asset as part of the cost of that asset.
Otherwise the cost are expensed in the period incurred
Eligible borrowing costs
• Borrowing costs that would have been avoided had
the expenditure on the qualifying asset not been made
• If funds borrowed for a specific qualifying assets, then the
costs eligible for capitalisation are the actual borrowing costs
less investment income on temporary investment of borrowings
• If general funds used, the costs eligible for capitalisation is
the expenditure on the qualifying asset multiplied by the
capitalisation rate
Answers to Knowledge Check Questions
Question 1
The total borrowing costs for the period ended 31 March 20X5 is HK$403,333 (calculated as
HK$22 million × 4/12 × 5.5%). However, borrowing costs can only be capitalised from the
commencement date, which is when the following three conditions must all be met:
1. HRC has incurred expenditures for the wind turbine;
2. HRC has incurred borrowing costs; and
3. HRC has undertaken activities that are necessary to prepare the wind turbine for its
intended use or sale.
Though the funds were borrowed on 1 December 20X4, the commencement date is
1 January 20X5 when expenditures have been incurred and activities to prepare the wind
turbine for its use or sale have taken place. As such, the total borrowing costs for the
period ended 31 March 20X5 that can be capitalised are HK$302,500 (calculated as HK$22
m × 3/12 × 5.5%).
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Entries as at 31 March 20X5
Debit Credit
HK$ HK$
Wind Turbine 302,500
Interest expense 100,833
Cash 403,333
(Recognition of borrowing costs)
Question 2
The total borrowing costs for the period ended 31 March 20X6 is HK$5.2 million (calculated
as HK$60 million × 5.5% + HK$40 million × 4.75%). However, borrowing costs can only be
capitalised from the commencement date, which is when the following three conditions
must all be met:
1. ABB has incurred expenditures for the bridge;
2. ABB has incurred borrowing costs; and
3. ABB has undertaken activities necessary to prepare the bridge for its intended
use or sale.
Though the funds had been borrowed since at least before the start of the financial
year, the commencement date was 1 January 20X6, when construction of the bridge
began. In addition, as the funds used were borrowed generally, ABB also had to determine
the amount of borrowing costs eligible for capitalisation. The capitalisation rate was the
weighted average of the borrowing costs of ABB, which in this case is 5.2% per annum
(calculated as 5.5% × HK$60 million/HK$100 million + 4.75% × HK$40 million/HK$100
million). This capitalisation rate was applied to the expenditures on the asset. In this case,
HK$17.5 million had been spent during the period (HK$35 million × 50%).
As such, the total borrowing costs for the period ended 31 March 20X6 that could be
capitalised were HK$227,500 (calculated as HK$17.5 million × 3/12 × 5.2%).
Entries as at 31 March 20X6
Debit Credit
HK$ HK$
Bridge 455,000
Interest expense 4,745,000
Cash 5,200,000
(Recognition of borrowing costs)
EXAM PRACTICE
QUESTION 1
On 30 March 20X8, Morrow Limited (Morrow) signed a HK$17 million contract with Teller
Limited (Teller) to construct a new manufacturing plant to expand its production of
motorcycles. The terms of the contract are that Morrow will pay 15% upon signing the
contract, 60% upon delivery and 25% four months after delivery.
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Construction began immediately upon signing the contract, and the manufacturing plant
was completed on 30 September 20X9.
In addition, Morrow purchased land on 1 June 20X8 for HK$5 million on the outskirts
of the city for the purpose of building a bike research and testing facility. Another HK$5
million was spent developing the land (i.e. clearing, levelling, etc.) prior to the construction
of the facility. This began as soon as the land was purchased and was paid upon completion
on 31 August 20X8. Construction on the facility began on 1 September 20X8. The total
cost of the facility construction (this does not include the cost of developing the land) was
HK$90 million, and it was completed on 31 December 20X9. The first payment occurred
on 1 November 20X8 and totalled HK$20 million. The remaining payments all took
place in 20X9.
Morrow drew on existing borrowings to fund the construction of the manufacturing
plant. The following provides details of the outstanding balances of the debt as at
31 December 20X7:
• 4.25% five-year note with interest paid annually; HK$30 million with this amount
remaining unchanged through to 31 December 20X8.
• 5.75% five-year note with interest paid annually; HK$40 million with this amount
remaining unchanged through to 31 December 20X8.
• 4.00% 20-year interest only loan through City Bank, with interest paid
annually; HK$20 million with this amount remaining unchanged through to
31 December 20X8.
To assist with funding, the construction of the bike research and testing facility, Morrow
organised a HK$100 million facility on 1 June 20X8 with North West Bank. Morrow only drew
down on the facility as funds were required. The interest rate was a fixed 6.50% per annum
during the period of construction.
Required:
You are the financial accountant of Morrow and have been charged with preparing the
note disclosure relating to Morrow’s capitalised borrowings. Prepare the note disclosure for
inclusion in Morrow’s financial statements for the year ended 31 December 20X8.
QUESTION 2
Adapted from Module A December 2016 Paper
Prime Estate Limited (‘PEL’) is a company listed on the Stock Exchange of Hong Kong
and is principally engaged in the real estate industry in mainland China. The functional
and presentation currency of PEL is Renminbi (RMB). PEL has grown over the past few
years through the acquisition of companies in mainland China. However, business was
tough in 20X8.
In the past few years, PEL, being a company engaged in the real estate industry in
mainland China, has issued loans in USD (USD loans) in the offshore markets to enjoy a
lower interest rate on its borrowings. As the RMB has been appreciating in the past years,
the exchange gain from the USD loans has been recognised by PEL in the income statement
because the RMB is the functional currency of PEL.
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However, the sharp devaluation of RMB in 20X8 has given rise to exchange losses for PEL
in the year ended 31 December 20X8. The exchange loss on USD loans resulting from the
devaluation of RMB in 20X8 has been capitalised in the financial statements.
Assume you are Peter Lim, the accounting manager. Ms. Helen Chan, a Director of PEL,
raised the following question:
‘You told me that exchange losses of foreign currency borrowing in entities with the
RMB as the functional currency have been capitalised in the qualifying assets to the extent
they are regarded as an adjustment to interest costs. Please advise as to the basis of this
capitalisation’.
ANSWERS TO EXAM PRACTICE
QUESTION 1
Manufacturing plant
The first step is to determine whether the manufacturing plant is a qualifying asset.
A qualifying asset is one that necessarily takes a substantial period of time to get ready for
its intended use or sale. In this case, the manufacturing plant is expected to take 18 months
to completely construct and make ready for use. Though a substantial period of time is not
defined in the standard, we can assume that 18 months is a substantial period of time, and
therefore, the manufacturing plant is a qualifying asset. This means that borrowing costs
directly attributable to the acquisition, construction or production of a qualifying asset are
included as part of the cost of that asset.
The second step is to determine when Morrow can begin capitalising the borrowing costs.
As noted previously, this occurs when all of the following conditions are met: (1) Morrow
incurs expenditures for the construction of the manufacturing plant; (2) Morrow incurs
borrowing costs; and (3) Morrow undertakes activities necessary to prepare the
manufacturing plant for its intended use. The first date all of these conditions are met is
30 March 20X8.
The third step is to determine the amount of borrowing costs to be capitalised
against the manufacturing plant. In this case, no funds have been borrowed specifically
for the construction of the manufacturing plant. As such, Morrow needs to multiply the
capitalisation rate to the expenditures made during the period. The capitalisation rate is
calculated as the weighted average of the borrowing cost applicable to the borrowings of the
entity that are outstanding during the period, other than borrowings made specifically for
the purpose of obtaining a qualifying asset.
During the period ended 31 December 20X8, Morrow had four separate borrowings,
two five-year notes, a HK$20 million loan from City Bank and a HK$100 million facility from
North West Bank (of which only HK$20 million had been drawn). As the facility from North
West Bank has been borrowed for the purpose of the bike research and testing facility, the
capitalisation rate is the weighted average of the borrowing cost of the notes, which in this
case, is 4.86% per annum (calculated as 4.25% × HK$30 million/HK$90 million + 5.75% ×
HK$40 million/HK$90 million + 4.00% × HK$20 million/HK$90 million).
Between the commencement date and 31 December 20X8, the only expenditure made
on the manufacturing plant was the HK$2.55 million payment made on the commencement
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date. As such, the total borrowing costs for the period ended 31 December 20X8 that can
be capitalised to the manufacturing plant are HK$92,969 (calculated as HK$2.55 million ×
9/12 × 4.86%).
Morrow records the following journal entry:
Entry as at 31 December 20X8
Debit Credit
HK$ HK$
Manufacturing plant 92,969
Cash 92,969
(Recognition of capitalised borrowing costs)
Note: the remaining borrowing costs are to be expensed in profit or loss and is not
illustrated here.
Bike research and testing facility
The first step is to determine whether the bike testing and research facility is a qualifying
asset. In this case, the redevelopment takes 19 months (1 June 20X8 through to
31 December 20X9), and as such, we can that it is a qualifying asset. The land and facility are
considered together as the land cannot be used independently of the facility.
This means that borrowing costs directly attributable to the acquisition, construction
or production of a qualifying asset are included as part of the cost of that asset. Because
the funds were specifically borrowed for the construction of the bike testing and research
facility, the borrowing costs eligible for capitalisation are the actual borrowing costs.
Morrow can only begin capitalising borrowing cost when all of the following three
conditions are met: (1) Morrow has incurred expenditures for the asset; (2) Morrow
incurs borrowing costs; and (3) Morrow is undertaking activities necessary to prepare
the development for its intended use. As the borrowing, work and initial payment for the
development all occurred on 1 June 20X8, this is the date on which capitalisation can begin.
Because the funds were borrowed specifically for the facility, the amount of borrowing
costs eligible for Morrow to capitalise are the actual borrowing cost incurred on that borrowing
during the period less any investment income on the temporary investment of those
borrowings. As Morrow only drew down on the loan facility as it required the funds, it did not
temporarily invest any of the borrowings related to the bike testing and research facility.
Period Calculation Amount
(HK$)
Actual borrowing costs relating to 1 June 20X8 − HK$5,000,000 189,583
land purchase 31 December 20X8 × 6.50% × 7/12
Actual borrowing costs relating to 1 September 20X8 − HK$5,000,000 108,333
site development 31 December 20X8 × 6.50% × 4/12
Actual borrowing costs relating to 1 November 20X8 − HK$20,000,000 216,667
facility construction 31 December 20X8 × 6.50% × 2/12
Eligible borrowing costs 514,583
Thus, the total borrowing costs eligible to be capitalised against the Morrow bike testing
and research facility construction as at 31 December 20X8 is HK$514,583.
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Morrow records the following journal entry:
Entry as at 31 December 20X8
Debit Credit
HK$ HK$
Bike testing and research facility 514,583
Cash 514,583
(Recognition of borrowing costs)
Morrow prepares the following note disclosure for inclusion in Morrow’s financial
statements for the year ended 31 December 20X8.
Note X: Finance costs
20X8 20X7
HK$’000 HK$’000
Interest expenses on bank and other borrowings 4,890 4,375
less: Amount capitalised to manufacturing plant 93 –
less: Amount capitalised to bike testing and research facility 515 –
4,282 4,375
During the year ended 31 December 20X8, Morrow capitalised interest expenses of HK$607,552.
HK$30 million was borrowed specifically in relation to the bike testing and research facility
construction. The remainder of the borrowing costs capitalised were in relation to the construction of
a new manufacturing plant. A capitalisation rate of 4.86% per annum was used in this case.
QUESTION 2
To : Ms. Helen Chan, Director
From : Peter Lim, Accounting Manager
Date : dd/mm/yyyy
Subject : Appropriate accounting treatment for the devaluation of Renminbi (RMB)
I refer to your query regarding the accounting treatment for the devaluation of
Renminbi (RMB).
Devaluation of Renminbi (RMB)
Borrowing costs are defined in HKAS 23 as ‘interests and other costs that an entity incurs in
connection with the borrowing of funds’. An entity shall capitalise borrowing costs directly
attributable to the acquisition, construction or production of a qualifying asset as part of the
cost of that asset.
Paragraph 6 of HKAS 23 specifies that borrowing costs may include exchange differences
arising from foreign currency borrowings to the extent that they are regarded as an
adjustment to interest costs.
The gains and losses that are adjustments to interest costs include the interest rate
differential between borrowing costs that would be incurred if the entity borrowed funds
in its functional currency and include borrowing costs actually incurred for foreign currency
borrowings.
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In general, foreign exchange differences can be considered as an adjustment to interest
costs if they narrow the cost differences between borrowings in functional and foreign
currencies.
In the past, the exchange gain from foreign currency borrowings together with its lower
interest rates would move the borrowing costs of RMB and USD borrowings further apart.
Accordingly, such exchange gain cannot be recognised as an adjustment to interest costs.
With the devaluation of the RMB, exchange losses arising from foreign currency
borrowings compensate for the lower interest rates of the foreign currency borrowings and
are likely to represent an adjustment to interest costs.
Such exchange losses bring the borrowing costs for borrowings in foreign currencies
and functional currency closer. They are, therefore, eligible for capitalisation in the qualifying
assets as part of the cost of that asset.
Therefore, exchange losses of foreign currency borrowing in entities with RMB as
functional currency can be capitalised in the qualifying assets to the extent that they are
regarded as an adjustment to interest costs.
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11
Intangible Assets
CHAPTER TOPIC LIST
11.1 Overview 11.3 Measurement after
11.1.1 Scope Recognition
11.1.2 Terminology 11.3.1 Cost Model
11.3.2 Revaluation Model
11.2 Recognition and Measurement
11.3.3 Useful Life
11.2.1 Separate Acquisition
11.3.4 Amortisation
11.2.2 Acquisition as Part of a
Business Combination 11.4 Retirements and Disposals
11.2.3 Acquisition by Way of a 11.5 Disclosure
Government Grant
11.2.4 Exchange of Assets 11.6 Current Developments
11.2.5 Internally Generated
Intangible Assets (Including
Research and Development)
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LEARNING OUTCOMES
PRINCIPAL LO3: EVALUATE AND ADVISE ON APPROPRIATE ACCOUNTING PRINCIPLES TO
ACCOUNT FOR COMPLEX BUSINESS TRANSACTIONS
LO3.05: A
ccount for, evaluate and advise business transactions in accordance with Hong Kong
Financial Reporting Standards as they relate to: Intangible assets
3.05.01 Describe the scope and definition of an intangible asset
3.05.02 Apply the definition of an intangible asset to both internally generated and purchased
intangibles
3.05.03 Account for the recognition and measurement of intangible assets
3.05.04 Account for the subsequent accounting treatment of intangible assets including amortisation
and impairment
3.05.05 Calculate the amortisation expense for various intangible assets
3.05.06 Advise on the accounting treatments of expenses incurred during research and
development phase
3.05.07 Analyse how goodwill arises
3.05.08 Evaluate and account for internally generated goodwill and goodwill arising on business
combination
3.05.09 Account for internally generated intangible assets and intangible assets acquired as part of
a business combination
3.05.10 Prepare and appraise disclosure in respect of intangible assets
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OPENING CASE
WFY LIMITED
T he We Feed You Group (WFY Limited) is Hong Kong’s largest multi-brand food outlet owner.
The group operates branded hawker stalls, specialty food shops, Hong Kong style fast food
outlets, Chinese pastry bakeries and cha chaan teng cafés throughout Hong Kong.
The group started operations with one hawker stall, growing the business to a current
network of over 35 hawker stalls through a reputation of reliable, fresh and tasty fare. Through
astute management, the hawker stalls were successful, and WFY Limited, the parent entity,
commenced a strategy of acquiring a broader portfolio of Hong Kong based retail food
companies using accumulated profits.
As part of its growth strategies, WFY Limited management studies the international food
trends. It believes Japanese cuisine will become popular in Hong Kong. Consequently, the
group acquired the exclusive rights to operate the Japanese restaurant franchise ‘Mushi
Mushi’ in Hong Kong. This has been moderately successful to date with seven franchise
locations opened.
Also, identifying a gap in the market, management quietly established an in-house
product development team to develop a take-home meal product targeted at time-poor,
medium-to-high income professionals. The product’s unique selling point is an affordable
restaurant quality three-course dinner for two in 30 minutes requiring minimal cooking ability.
The product development team has spent some time researching the market and developing
trial products.
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OVERVIEW
The market has always understood the value of an entity to be more than its ‘bricks and mortar’
(e.g. a building). There is value in patents and licences held, goodwill attributed to the entity
and other assets of a non-physical nature. However, as more and more businesses embrace
new technologies and increasingly rely on assets such as software solutions to support or drive
revenue streams, it is necessary to understand and appreciate how HKFRS require intangible
assets to be accounted for, and further, to critically contemplate whether current accounting
treatments are adequate.
The application of the principles of HKAS 38 Intangible Assets can require the exercise of
significant judgement. Challenges for practitioners in accounting for intangible assets mainly
relate to:
• identifying whether a recognisable intangible asset exists because it may be difficult for
an entity to demonstrate control of probable future economic benefits; and
• measuring the intangible asset because its cost (or other carrying amount) may not be
as easily established compared to a tangible asset.
This chapter discusses the identification, recognition, measurement and disclosure of
intangible assets other than purchased goodwill.
1 1 . 1 OVERVIEW
The accounting for intangible assets is specified by HKAS 38 Intangible Assets. Generally, the
accounting for intangible assets is consistent with that for property, plant and equipment, being
the ability to recognise an intangible asset at cost and to subsequently measure the intangible
asset using the cost model or a revaluation model. The focus of this chapter, therefore, is on
the complexities in applying these accounting principles to intangible assets.
However, before getting into these principles, an entity needs to understand whether it has
an intangible asset that can be recognised. Not all intangible resources will meet the definition
of an intangible asset, and not all intangible assets are within the scope of HKAS 38.
11.1.1 Scope
HKAS 38 applies to the accounting for all intangible assets other than:
• Financial assets as defined in HKAS 32 Financial Instruments: Presentation (see Chapter 12);
• The recognition and measurement of exploration and evaluation assets (see Chapter 26);
• Expenditure on the development and extraction of minerals, oil, natural gas and similar
non-regenerative resources (see Chapter 26); and
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• Those intangible assets that are specifically within the scope of another HKFRS, including:
°° goodwill acquired in business combinations (see Chapter 29);
°° intangible assets held by an entity for sale in the ordinary course of business
(inventory – see Chapter 6);
°° deferred tax assets (see Chapter 19);
°° leases of intangible assets accounted for in accordance with HKFRS 16 Leases
(see later text);
°° assets arising from employee benefits (see Chapter 23);
°° contracts within the scope of HKFRS 17 Insurance Contracts (see Chapter 26);
°° non-current intangible assets classified as held for sale (or included in a disposal
group that is classified as held for sale) in accordance with HKFRS 5 Non-current
Assets Held for Sale and Discontinued Operations (see Chapter 15); and
HKAS °° assets arising from contracts with customers that are recognised in accordance with
38.2–3 HKFRS 15 Revenue from Contracts with Customers (see Chapter 5).
Rights held by a lessee under licensing agreements for items, such as motion picture films,
video recordings, plays, manuscripts, patents and copyrights are treated as intangible assets
HKAS 38.6
under HKAS 38 (this chapter) and not as right-to-use assets under HKFRS 16 Leases (see
HKFRS
16.3(e)–4 Chapter 9). As noted in Chapter 9, leases of other intangible assets can be accounted for under
HKAS 38.6 HKAS 38 or HKFRS 16.
11.1.2 Terminology
HKAS An intangible asset is defined as an identifiable non-monetary asset without physical
38.8 substance. The characteristics of an intangible asset are summarised in Exhibit 11.1 and
expanded on further in this section and in Section 11.1.2.3.
An intangible asset in identifiable An intangible asset is an Asset
Identifiability distinguishes an intangible An asset is a resource controlled by an entity
asset from goodwill. ‘Goodwill’ represents as a result of past events and from which
those future economic benefits that are not future economic benefits are expected to
individually identifiable and recognisable. flow to the entity.* The future economic
The accounting treatment for goodwill and benefits may be in the form of revenues,
other intangible assets differ. Intangible cost savings or other benefits.
An asset is identifiable if it is either separable asset Control is demonstrated by the entity having
from the entity or arises form contractual or An identifiable the power to obtain the future economic
other legal rights. non-monetary benefits flowing from the underlying
asset without resource and to restrict the access of others
physical to those benefits.
substance
An intangible asset in Non-Monetary An intangible asset has No Physical Substance
Monetary assets are money held and assets An asset that has physical substance is not
to be received in fixed or determinable an intangible asset.
amounts of money. A feature of a
non-monetary asset therefore is the absence
of a right to receive a fixed or determinable
amount of money.
*The definition of an asset in HKAS 38 differs from the term as defined in the Conceptual Framework for financial Reporting (2018).
It is not expected to result in a difference in application.
EXHIBIT 11.1 Characteristics of an intangible asset
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An item that does not demonstrate one (or more) of these characteristics is not an
intangible asset recognised by HKAS 38. The first part of the definition that must be established
is whether the entity has an asset.
11.1.2.1 Existence of an Asset: Demonstrating Control of a Resource
Examples of resources of an intangible nature include those protected by legal or contractual
rights (e.g. patents) and those that are not (e.g. employee skills and knowledge). In many cases,
in the absence of an enforceable legal right, an entity will be unable to establish it sufficiently
controls a resource of an intangible nature.
For example, absent legal rights, an entity does not usually have the sufficient power to
obtain the expected future economic benefits arising from the skills and knowledge of its
assembled workforce for the workforce to meet the definition of an intangible asset (see also
Section 2.3.1.1 in Chapter 29). This is because, for example, employees could resign or behave
in a manner that does not demonstrate those skills. Similarly, an entity may be unable to
demonstrate it has sufficient control over market share as the entity does not have the ability
to direct potential customers to behave in a manner that would generate future economic
benefits for the entity and restrict the access of others to those benefits.
Illustrative Example 1
WFY Limited has actively worked to develop its customer relationships such that it now
has a loyal customer base and an annual expected minimum level of revenues from
those customers. When assessing whether it has an intangible asset representing the
expected future economic benefits arising from its customer relationships, WFY Limited
first considers whether it has an asset.
WFY Limited has an asset if it can control the customer relationship resource. WFY
Limited determines it does not have sufficient control of the future economic benefits
in the form of sales revenues arising from its customer relationships because, although
it expects them to do so, it does not have the ability to compel (legally or otherwise) its
customers to purchase its goods. For example, long-standing customers could boycott the
company in objection to its position on certain social issues or in response to unflattering
media reports.
Consequently, WFY Limited determines the customer relationship resource is not an
asset. Hence, the customer relationship is not an intangible asset of WFY Limited.
Alternative 1
Assume there is evidence of exchange transactions for similar food and beverage-related
customer relationships in WFY Limited’s jurisdiction. In this case, though WFY Limited’s
customer relationships are not protected by legal rights, the existence of exchange
transactions for similar customer relationships provides evidence that WFY Limited
can control expected future economic benefits flowing from the customer relationship.
This is because WFY Limited can obtain future economic benefits from the customer
relationship by selling the customer relationship resource to another party.
WFY Limited will have an intangible asset to recognise in this instance if the other
aspects of an intangible asset and the recognition criteria (Section 11.2) are met.
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Illustrative Example 1 (continued)
Alternative 2
Assume instead that, from a third party, WFY Limited acquires a customer contract
requiring the customer to purchase 100,000 units of Product A from WFY Limited. In this
case, WFY Limited may assess it has control of the future economic benefits arising from
that contract because it can contractually compel the customer to purchase its goods
and, in so doing, restrict competitors from those revenues or to seek legal remedy for
the customer’s failure to comply with the contract.
WFY Limited will have an intangible asset to recognise in this instance if the other
aspects of an intangible asset and the recognition criteria (Section 11.2) are met.
Key Learning Point
For the purposes of determining whether it controls an intangible resource, the entity
should critically consider whether it has the ability or capacity to direct that resource in
a manner that would enable the entity to obtain future economic benefits from it and to
restrict the access of others to those benefits.
11.1.2.2 Of No Physical Substance: Assets That Include Both Intangible and
Tangible Elements
Some assets have tangible and intangible elements, for example, intangible assets contained
in or on a physical form (e.g. legal documentation for a licence) or those that operate in
conjunction with a host tangible asset (e.g. computer software in a drone). The entity assesses
HKAS which element is more significant when determining whether the asset has ‘no physical
38.4 substance’.
Illustrative Example 2
WFY Limited purchases a new mobile phone and downloads a navigation app to
the phone.
The mobile phone’s operating system is an integral part of the mobile phone hardware
as the mobile phone cannot operate (as a mobile phone) without that operating system
and, hence, is treated as property, plant and equipment. WFY Limited controls a single
property, plant and equipment asset whose components include the tangible phone
hardware and the intangible operating system housed in that hardware.
Though operational only in conjunction with the mobile phone, the navigation app
is not an integral part of the mobile phone hardware because the mobile phone is not
dependent on the app to be functional. Here, there is not a single asset combining the
tangible phone hardware and intangible navigational app. WFY Limited considers the
navigation app as an intangible asset separate from the tangible phone asset.
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In making its judgements, an entity should recall that to be useful, financial information
must represent relevant phenomena and must faithfully represent the substance of the
phenomena that it purports to represent. For example, the substance of a licence is not the
paper conveying the rights to use the item under licence but the right itself. Similarly, the
substance of a prototype is the knowledge embodied in it, not the physical representation of
the prototype itself.
11.1.2.3 Identifiability
The primary reasons that resources fail to meet the definition of an intangible asset are
because control of the resource is absent or because the item is not identifiable.
Identifiability distinguishes each source of expected future economic benefits. Exhibit 11.2
sets out when an asset is ‘identifiable’. An asset is identifiable if it meets either or both
conditions.
As asset is identifiable if it is separable or arises
from contractual or other legal rights
Is the asset separable? Doses the asset arise from contractual or other
Asset is capable of being separated or divided from the legal rights?
entity and sold, transferred, licenced, rented or exchanged Asset is protected by contractual or other legal rights
• Transfer can occur individually or together with a related • Rights need not be transferable or separable from
contract, identifiable asset or liability the entity or from other rights and obligations
• Need only be ‘capable’ – entity does not need to intend to • For example, a technology patent that is licenced
transfer or licence the asset for the separability criterion to a third party meets the criterion even though it
to be met would not be practical to separate the patent from
• Criterion met where there is evidence of exchange the related licence
transactions for that type of asset or an asset of a
similar type, even if those transactions are infrequent
(e.g. customer list)
NO YES YES NO
Asset fails the definition of Asset meets the identifiability Asset fails the definition of
an intangible asset criterion for an intangible asset an intangible asset
✓ Asset is also ✓ non-monetary and
✓ without physical substance
Consider whether recognition
Intangible asset exists
criteria met (Section 2)
EXHIBIT 11.2 Establishing identifiability
Apply and Analyse 1
WFY is exploring whether to allow customers to pay for food orders with cryptocurrency,
for example ‘Foodcoin’, which is a virtual currency:
• Is recorded on a distributed ledger that uses cryptography for security;
• Is not issued by a jurisdictional authority or similar other party; and
• Does not give rise to a contract between the holder and another party.
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Apply and Analyse 1 (continued)
The Foodcoin holder has a cryptographic private key that gives the holder exclusive
control over the Foodcoin. The holder can use the Foodcoin in exchange for other goods
or services or convert it into a legal currency using an exchange platform. The price of
Foodcoin fluctuates, similar to how a legal currency fluctuates.
WFY Limited’s management is interested to understand how any holdings of Foodcoins
would be treated in its financial statements.
The finance team has concluded that Foodcoin is not a financial asset in accordance
with HKAS 32 because Foodcoin does not meet the definitions of a financial asset as a
cryptocurrency:
• It is not cash;
• It is not an equity instrument of another entity;
• It does not give rise to a contractual right for the holder (the holder does not
have a contractual right to receive cash or another financial asset from another
entity); and
• It is not a contract that will or may be settled in the holder’s own equity
instruments (see Chapter 12).
The finance team determined that Foodcoin is not cash even though Foodcoins will
be used as a medium of exchange for its goods and services. It reached this conclusion by
evaluating Foodcoin against the characteristics of cash in HKAS 32, where cash is expected
to be used as a medium of exchange and as the monetary unit in pricing goods or services
to such an extent that it would be the basis on which all transactions are measured
and recognised in financial statements. The finance team observed that Foodcoin is
not currently used to such an extent that it would be an appropriate basis on which to
measure all transactions in the WFY financial statements.
The finance team is now considering whether Foodcoin holdings would be classified as
an intangible asset or inventory. Analyse whether Foodcoins received by WFY Limited meet
the definition of an intangible asset.
Analysis
An intangible asset is an identifiable non-monetary asset without physical substance.
A Foodcoin is:
• an asset – the holder does not have a legal right against another party for the
‘value’ in the Foodcoin because Foodcoin is not a regulated currency. However, the
holder has control over the Foodcoin and its expected future economic benefits
because the holder has the ability to use the Foodcoin to obtain other goods or
services or to convert it into a legal currency.
• without physical substance – Foodcoin is a virtual currency and, therefore, has no
physical substance. The paper on which the cryptographic private key might be
printed (e.g. as a record of the holding) is secondary to the substance of the asset.
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Apply and Analyse 1 (continued)
• non-monetary – Foodcoin is not money (i.e. cash) and, because no contractual
relationship exists with another party, it does not give the holder a right to receive
a fixed or determinable number of units of currency. As such, it is non-monetary
in nature.
• identifiable – Foodcoin is capable of being separated from the holder and sold or
transferred individually because it can be converted into cash or used to obtain
goods or services. Therefore, it is an identifiable asset.
As such, Foodcoins received by WFY Limited meet the definition of an intangible asset.
However, before concluding that Foodcoins as an intangible asset should be treated in
accordance with HKAS 38, WFY Limited must consider whether the Foodcoins are scoped
out of the HKFRS because they are inventory. As WFY Limited does not hold cryptocurrency
for sale in the ordinary course of its business, its Foodcoin holdings do not meet the
definition of inventory. Hence, WFY Limited would account for any Foodcoin holdings in
accordance with HKAS 38.
Note: The preceding analysis has been developed with regard to the IFRS Interpretations
Committee June 2019 Agenda Decision ‘Holdings of cryptocurrency’. This is an area where
accounting practice may develop further as standard-setters are challenged to consider whether
current accounting treatments provide the most useful information about crypto-assets to users
of the financial statements. At the time of publication, the IASB does not have a project in this
regard on its work programme.
Note: Candidates are encouraged to revisit this exercise after studying Chapter 12 to review
the conclusion that the virtual currency is not a financial asset.
Key Learning Point
Not all assets without physical substance are intangible assets. An entity must consider
whether all the features of an intangible asset are met.
Knowledge Check Questions
Question 1
Determine which one of the following items is not an identifiable asset.
A Customer list
B Royalty rights
C Gaming licence
D Organised workforce
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Knowledge Check Questions (continued)
Question 2
Insta Flix Limited (IFL) operates a digital streaming service that allows subscribers to watch
its library of TV shows, movies and other programmes on supported internet-connected
devices. The IFL library is comprised of programmes produced and owned by IFL and
those over which it holds distribution rights under licence from the owners. Subscribers
are unable to save the programmes on their own devices to watch after their subscription
ends or to on-sell their access to the library.
Analyse whether IFL has one or more intangible assets to account for under HKAS 38.
1 1 . 2 RECOGNITION AND MEASUREMENT
This section discusses when the recognition criteria for an intangible asset are met, and
describes how cost is measured, having regard to different ways by which an intangible asset
can be acquired.
An intangible asset is recognised only when:
• The expected future economic benefits will probably be attributable to the asset will
flow to the entity; and
HKAS
38.21 • The cost of the asset can be measured reliably (the ‘general recognition criteria’).
In some cases, the assessments of whether an intangible asset exists (Section 11.1.2) and
whether it qualifies for recognition are interrelated and are considered together. This will often
be the case for internally generated intangible assets because control of a resource embodying
an asset is unlikely to exist until the time of recognition.
A recognised intangible asset is measured initially at its cost.
In many cases, the cost of an intangible asset will not increase after initial recognition
(reflecting capital improvements), as given the nature of intangible assets’ subsequent expenditure
tends to show maintenance of the existing asset and/or because the expenditure cannot be
attributed to a particular intangible asset rather than to the business as a whole, for example:
• The annual fee paid to an internet domain name registrar to use a website address
maintains, rather than increases, the level of future economic benefits of that intangible
asset; and
• Subsequent marketing expenditure to improve brand recognition cannot be attributed
HKAS to the intangible asset ‘brand name’ as the marketing arguably also improves related
38.20, 24 trademarks, franchise rights, general entity performance, and so on.
Expenditure that does not qualify for recognition as a separately identifiable intangible
asset is expensed as incurred except where it forms part of goodwill recognised in a business
combination (see Chapter 29). Expensed expenditure cannot be recognised as part of the cost
of an intangible asset at a later time, including instances when future events prove their
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recoverability. Examples of such expenses include expenditure on research, training staff,
HKAS start-up costs (unless included in the cost of property, plant and equipment), relocating or
36.68–71 reorganising part or all of an entity, and expenditures on advertising and promotional activities.
11.2.1 Separate Acquisition
With regards to whether a separate acquisition of an intangible asset (e.g. purchase of a licence)
satisfies the criteria for recognition:
• the probability of flow of future The probability criterion is always met, as the purchase
economic benefits would not occur if the acquirer did not expect future
economic benefits from that asset to flow to the entity.
• a reliable measurement of the cost The reliable measurement criterion is usually met, as cost is
given by the sum of determinable:
• purchase price, including import duties and non-refundable
purchase taxes, after deducting trade discounts and
rebates; plus
• directly attributable costs of preparing the asset for its
intended use.
Generally, an acquired intangible asset is recognised on acquisition.
Refer to Sections 7.3.1.2 and 7.3.1.4 of Chapter 7 for examples of directly attributable costs
and expenditures that are not included as part of the cost of an intangible asset. The
recognition of costs in the carrying amount of the intangible asset stops when the asset is in
HKAS the condition necessary for it to be capable of operating in the manner intended by
38.30 management.
11.2.2 Acquisition as Part of a Business Combination
HKFRS 3 (Revised) Business Combinations requires an acquirer in a business combination to
separately recognise all identifiable intangible assets acquired in the business combination. These
intangible assets are generally measured at their fair values (see Sections 29.2.3.2–29.2.3.3 of
Chapter 29), which becomes the initial cost of the asset going forwards.
The recognition criteria specified by HKFRS 3 (Revised) overrides the general recognition
criteria specified in HKAS 38 (set out at the start of Section 11.2). However, in practice, it gives
the same outcome because an identifiable intangible asset acquired as part of a business
combination always satisfies the HKAS 38 criteria for recognition of an intangible asset:
• the probability of flow of future The probability criterion is always met, as fair value reflects
economic benefits market participant expectations about the probability that
expected future economic benefits from that intangible asset
will flow to the entity.
• a reliable measurement of the cost The reliable measurement criterion is always met, as implied
by the identifiability of the intangible asset. If an intangible
asset is separable from the entity or arises from contractual
HKAS or other legal rights, sufficient information exists to measure
38.33 reliably its fair value and, hence, its cost.
Not all intangible assets recognised by the acquirer will also be recognised by the
acquiree. For example, a customer list recognised by an acquirer is often not recognised by the
acquiree. This is because, as set out in the other parts of this chapter (notably, Section 11.2.3),
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the application of the recognition criteria might lead each entity to have a different conclusion.
Because the acquirer recognises the intangible asset, it must also consider whether to account
for any deferred tax consequence of that asset. This is discussed further in Chapters 19 and 29.
’Identifiable intangible asset’ is the language used in HKFRS 3 (Revised). The reference to
‘identifiable’ may confuse, given that the definition of an intangible asset includes identifiability
as a core feature. In practice, no differences are expected to arise between the term ‘intangible
asset’ and ‘identifiable intangible asset’.
The accounting for business combinations is discussed in Chapter 29.
11.2.2.1 Goodwill Arising in a Business Combination
Goodwill arising in a business combination is an asset representing the future economic
HKFRS benefits arising from other assets acquired in a business combination that are not individually
3(R).App A identified and separately recognised, which is, in effect, an ‘unidentifiable intangible asset’. As
noted in Section 11.1.1, the accounting for goodwill arising in a business combination is
specified by HKFRS 3 (Revised) and not HKAS 38.
Goodwill reflects an expectation that future economic benefits will flow to an entity other
than from the separately recognised assets. Goodwill arising in a business combination is
reliably measurable as it can be quantified, being calculated as the residual after allocation of
the consideration for the business combination to other assets acquired and liabilities assumed.
In accordance with HKFRS 3 (Revised), goodwill arising in a business combination is
recognised as an asset by an acquirer on the acquisition date. Subsequently, the recognised
goodwill is not amortised but is tested annually for impairment. Refer to Chapter 29
to understand how to initially measure and account for goodwill arising in a business
combination, and Chapter 14 for how to subsequently test the recognised goodwill for
impairment and to calculate and account for any impairment losses.
11.2.3 Acquisition by Way of a Government Grant
An entity may be granted rights, quotas, licences, or other types of intangible assets from a
government free of charge or for a nominal cost. Situations where this may occur include
airport landing rights, licences to operate radio or TV stations, import licences or quotas, or
rights to access other restricted resources.
The granted intangible asset always satisfies the recognition criteria as:
• the probability of flow of future The probability criterion is met because the presumption is
economic benefits the government is transferring something of value (an asset)
to the entity
• a reliable measurement of the cost The reliable measurement criterion is met because the
related intangible asset is measured at a determinable fair
value or a nominal amount plus any expenditure directly
attributable to preparing the asset for its intended use.
The intangible asset is measured at fair value or at a nominal amount plus any directly
attributable costs to preparing the asset for its intended use.
This amount becomes the initial cost of the intangible asset going forwards. Note, the
HKAS measurement of the asset must be consistent with the basis adopted for the measurement of
20.23, 38.44 the grant (see Chapter 22).
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11.2.4 Exchange of Assets
Intangible assets may be acquired in a swap for other assets. An intangible asset acquired by
way of a swap satisfies the criteria for recognition as:
• the probability of flow of future The probability criterion is always met because the purchase
economic benefits would not occur if the acquirer did not expect future
economic benefits from that asset to flow to the entity.
• a reliable measurement of the cost The reliable measurement criterion is met because the asset
is measured by reference to a reliably measurable fair value
or by reference to the known carrying amount(s) of the
asset(s) given up in exchange.
The cost of an acquired intangible asset is:
• The fair value of the asset(s) given up;
• The fair value of the asset received; or
HKAS
38.45, 47 • The carrying amount(s) of the asset(s) given up.
As for property, plant and equipment, the cost of an intangible asset acquired in an
exchange of assets is not an election: A hierarchy applies to establishing the cost. Refer to
Section 7.3.2.1 of Chapter 7 for the accounting in this regard.
11.2.5 Internally Generated Intangible Assets (Including Research
and Development)
HKAS 38 specifies additional requirements and guidance for recognition of an internally
generated intangible asset in addition to the general recognition criteria set out at the start of
Section 11.2.
As part of establishing whether recognition of an internally generated item is appropriate,
HKAS
HKAS 38 requires an entity to classify the generation of the intangible asset into a research
38.52 phase and a development phase.
These two phases, and their relevance to recognition, are discussed in Sections 11.2.5.1
and 11.2.5.2.
Following the research and development phases comes the operation phase, where the
asset stands ready to generate future economic benefits for the entity. Not all acquired
intangible assets will be in the operations phase. For example, an acquired in-process research
and development (IPR&D) project for the development of a new drug will not be at the
operations phase. Accordingly, post-acquisition, until the asset is capable of operating in the
HKAS manner intended by the acquirer, any expenditure on the asset is classified appropriately as
38.42 either research or development phases.
11.2.5.1 Research Phase
HKAS Research is original and planned investigation undertaken with the prospect of gaining new
38.56 scientific or technical knowledge and understanding.
The standard-setters concluded that an entity is unable to demonstrate that expenditure
HKAS on research or on the research phase of an internal project will probably generate future
38.55 economic benefits. Hence the definition of an intangible asset and criteria for recognition
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cannot be met. Consequently, no intangible asset can be recognised for expenditure incurred
HKAS on research or on the research phase of a project. Instead, such expenditure is recognised as
38.54 an expense in profit or loss.
HKAS Where the research phase cannot be distinguished from the development phase,
38.53 expenditures are treated as if the expenditure were incurred in the research phase.
11.2.5.2 Development Phase
Development is the application of research findings or other knowledge to a plan or design for
HKAS the production of new or substantially improved materials, devices, products, processes,
38.8 systems or services before the start of commercial production or use.
Development activities are akin to the ‘build’ stage of a project or the execution of the
idea once the concept and specifications have been agreed. Examples of development
activities include:
• The design, construction and testing of pre-production or pre-use prototypes
and models;
• The design of tools, jigs, moulds and dies involving new technology;
• The design, construction and operation of a pilot plant that is not of a economically
feasible scale for commercial production; and
HKAS • The design, construction and testing of a chosen alternative for new or improved
38.59 materials, devices, products, processes, systems, or services.
An intangible asset arising from development or from the development phase of an
internal project is recognised only when all of the six additional criteria are met:
1. Completion is technically feasible. It is technically feasible the intangible asset will be
completed to a stage that it will be available for use or sale.
2. Completion is intended. The entity intends to complete the intangible asset and use
or sell it.
3. No barriers exist to completion. Adequate technical, financial and other resources are
available to the entity to complete the development and to use or sell the intangible
asset. This can be demonstrated through, for example, a business plan showing the
technical, financial and other resources needed and the entity’s ability to secure those
resources or evidence of external financing provided by lending institutions, investors
or government departments.
4. The asset can be used or sold. The entity has the ability to use or sell the intangible
asset. This differs from the next criteria as an intangible asset can be in use but not
generate any future economic benefits; however, an intangible asset that cannot be
used or sold has no probable expected future economic benefits.
5. Future economic benefits are demonstratable. The entity can demonstrate how
the intangible asset will generate probable future economic benefits for the entity,
including by providing evidence that a market exists for the intangible asset or its
output or, where the asset will be used internally, the usefulness of the intangible
asset. Future economic benefits are assessed using the principles of HKAS 36
(see Chapter 14).
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It may be that the commercial viability of a product subject to regulatory approval is
not demonstratable until that approval is obtained. For example, it may not be possible
for an entity developing a new pharmaceutical drug to meet these criteria until the drug
is approved for sale by the relevant regulatory authority; and
6. A cost can be measured reliably. The entity can measure reliably the expenditure
HKAS
attributable to the intangible asset during its development (e.g. wages and salaries, fees
38.57, 60–62 to register a copyright).
Meeting these additional criteria also provides evidence of the general recognition being
met because there will be:
• An asset – criteria (1) to (4) in the preceding list demonstrate that the entity has control
of future economic benefits arising from the resource;
• Which can be expected to generate future economic benefits for the entity; and
• Whose cost can be reliably measured.
Examples of how the criteria may be evidenced include:
• The existence of business plans showing the technical, financial and other resources
needed and the entity’s ability to secure the resources;
• A lender’s indication of its willingness to fund the project demonstrates the availability
of external finance; and
HKAS
38.61–62 • Costing systems that can (and does) capture detailed project related costs.
Brands, Mastheads, Publishing Titles and Customer Lists
The cost of internally generated brands, mastheads, publishing titles, customer lists and items
similar in substance cannot be distinguished from the cost of developing the business as a
HKAS whole. As such, the ‘cost’ cannot be reliably measured and, consequently, such items cannot be
38.63 recognised by the entity developing the asset.
Key Learning Point
Not all costs incurred in the development phase qualify for recognition as an intangible
asset.
11.2.5.3 Cost of an Internally Generated Asset
The cost of an internally generated intangible asset is the sum of expenditures incurred from
the date when the intangible asset first satisfies all the specified criteria for recognition. It
HKAS comprises all directly attributable costs necessary to create, produce and prepare the asset to
38.65–66 be capable of operating in the manner intended by management.
The cost of an internally generated intangible asset does not include:
• Costs of training staff to operate the intangible asset;
• Identified inefficiencies; and
HKAS
38.67 • Initial operating losses incurred before the asset achieves planned performance.
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The flowchart in Exhibit 11.3 summarises the accounting treatment of expenditure incurred
on an internally generated intangible asset.
Is the expenditure incurred in the YES
research phase of the project?
The expenditure is expensed as incurred
NO
Is the expenditure incurred in the NO
development phase of the project?
YES
Has development reached a stage NO
where capitalisation is appropriate?
YES
Is the expenditure a directly
attributable cost that is necessary
to create, produce and prepare the NO
asset to be capable of operating
in the manner intended by
management?
YES
The expenditure forms part of the
initial measurement (cost) of the
intangible asset
EXHIBIT 11.3 Initial measurement of
an internally generated intangible
asset
Apply and Analyse 2
WFY Limited created a project team to explore developing take-home meals. Between the
project start to 30 June 20X0, WFY Limited was investigating the market to see whether it
would be feasible to start a venture into the take-home meals market, what products to
develop and how to manage the production process (e.g. outsource or in-house). During
this time, it incurred project team salary costs and costs to conduct market research and
field test a wide variety of recipes.
On 1 July 20X0, the directors discussed the venture at a WFY Limited board meeting.
WFY Limited management reported to the board that their market research suggested
there was a demand for supermarkets to sell take-home meals targeted at the time poor
and middle-to-high income professional. Management recommended the company
proceed with the project with an initial product range of the eight best-reviewed meals
from the test product options. Having explored the various options available, management
proposed to the board to outsource the production to an identified third-party supplier
using WFY Limited recipes and packaged to WFY Limited specifications. The meals would
be delivered from the supplier’s warehouses straight to the supermarkets. WFY Limited
had no resource barriers to producing the meals.
At the meeting, the board voted to proceed with the project and directed management
to begin development of the take-home meal products consistent with the management
proposals. Production began 15 December 20X0. On 1 January 20X1, WFY Limited officially
launched its take-home meal range for purchase in selected supermarkets under the trade
name ‘Dine In’.
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Apply and Analyse 2 (continued)
Between 1 July 20X0 and 1 January 20X1, WFY Limited incurred costs for:
• Consultant chef fee to develop final recipes – HK$2 million
• Recipe copyright registration – HK$0.2 million
• Trademark registration – HK$0.3 million
• Dedicated project team salaries – HK$2.5 million
• Advertising to announce the new products – HK$0.5 million
WFY Limited estimates that the project team probably spent about 10% of its time
on activities relating to recipe development but had not kept any detailed timesheets in
this regard.
Analyse whether WFY Limited can recognise an intangible asset for the product recipes
and, if so, the initial measurement of the asset.
Analysis
Assessment against the definition
The product recipes meet the definition of an intangible asset as:
• There is an asset – As WFY Limited has developed the recipe, it has control of the
expected future economic benefits from sale or use of that recipe. Once it has
copyright, it will also be able to restrict the access of others from producing the
exact same product as WFY Limited.
• The asset is without physical substance – The substance of the asset is the
ingredients and the process for turning the list of ingredients into a meal. The
paper on which the recipe might be detailed (e.g. as a record of the recipe for
production or other purposes) is secondary to the substance of the asset.
• The asset is non-monetary – A recipe is not money (i.e. cash) and does not give WFY
Limited a right to receive a fixed or determinable number of units of currency. As
such, it is non-monetary in nature.
• The asset is identifiable – The assets arises from legal copyright rights. Therefore,
it is an identifiable asset. In addition, a recipe is capable of being separated from
WFY Limited and sold or transferred individually; this also provides evidence of its
identifiable nature.
Assessment against the recognition criteria for internally developed intangible assets
Research phase:
Having regard to the types of activities undertaken, up to 30 June 20X0, WFY Limited was
in the research phase of the project. In accordance with HKAS 38, expenditures during this
phase (e.g. costs of market research) are not recognisable as an intangible asset but are
expensed as incurred.
Development phase:
WFY Limited determined that the project is in the development phase from 1 July 20X0,
when the board of directors approved the project for development in accordance with the
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Apply and Analyse 2 (continued)
proposed project specifications. In addition, on 1 July 20X0, WFY Limited met the criteria for
recognition of costs for intangible assets related to the project as from that date the entity
can demonstrate that:
(a) Completion of the intangible asset is technically feasible as the development of
recipes does not require any significant technical requirements;
(b) Completion is intended as the board has decided to proceed with the project;
(c) There are no technical, financial and other resources constraints on completion
of the project;
(d) The recipes can be used or sold to generate future economic benefits;
(e) Future economic benefits are demonstratable as the products will be sold
in supermarkets and the entity’s market research provides evidence that a
demand for the take-home meals exists; and
(f) A cost can be measured reliably as the entity can identify project related
expenditure.
Initial measurement of the asset
Once the criteria for recognition are met (1 July 20X0), WFY Limited recognises any
directly attributable costs, which are necessary to create, produce and prepare the
asset to be capable of operating in the manner intended by management as part of
the cost of the intangible asset. Capitalisation ceases when the asset is ready for use;
for the product recipes, this would be when the copyright is granted (i.e. before 15
December 20X0).
The cost of the recipe intangible asset is the sum of the:
• Consultant chef fee to develop final recipes – HK$2 million; and
• Recipe copyright registration – HK$0.2 million.
That equals HK$2.2 million. The cost is amortised over the useful life of the recipes
(discussed in Section 11.3).
Note 1: Because employee time cannot be directly attributed to the recipes, the related
portion of the project team salaries cannot be included as part of the cost of the asset even
though these are costs necessarily incurred to create the asset (e.g. administrative costs of
preparing any necessary documentation).
Note 2: Advertising costs are not directly attributable costs of an intangible asset.
Note 3: Even though the take-home meals ultimately result in probable future cash
flows for WFY Limited, in accordance with HKAS 38, any previously expensed product
testing costs and other directly attributable costs of the recipes intangible asset cannot be
retrospectively capitalised as part of the intangible asset.
Note 4: Other intangible assets might be recognisable separate from the recipes,
for example, the ‘Dine In’ trademark.
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11.2.5.4 Website Development (HK(SIC)-Int 32)
HK(SIC)-Int 32 Intangible Assets–Web Site Costs was issued to provide guidance on the application
of HKAS 38 to internally developed external websites and intranets. The interpretation clarifies
that expenditure incurred to develop a website follows two criteria:
1. It solely or primarily promotes and advertises an entity’s own products and
services – it is expensed as incurred because the entity is unable to demonstrate
how such a website will generate probable future economic benefits for the entity
(i.e. the entity cannot satisfy the recognition criteria ‘future economic benefits are
demonstratable’ – see Section 11.2.5.2).
2. It is capable of generating revenues (e.g. online sales) – it may be recognisable as an
intangible asset provided all other conditions for recognition are met because the entity
HK(SIC)– can demonstrate that such a website will generate probable future economic benefits
Int 32.8 for the entity.
HK(SIC)– Exhibit 11.4 sets out the different website stages and the accounting treatment of
Int32.IE associated expenditures.
Website stage Example activities Accounting treatment
I. Planning • Undertaking feasibility studies Expense as incurred
(Research phase) • Defining hardware and software
specifications
• Evaluating alternative products
and suppliers
• Selecting preferences
II. A
pplication and • Purchasing or developing hardware Recognise in accordance with
Infrastructure HKAS 16 (see Chapter 7)
Development • Obtaining a domain name Expense as incurred, except when
(Development phase) all the following conditions are met:
• Developing operating software
• Developing code for the application • the website meets the general
recognition criteria (refer to the
• Installing developed applications on
start of Section 11.2)
the web server
• the development of the
• Stress testing
website has reached a stage
III. G
raphical Design • Designing the appearance where capitalisation may be
Development of web pages appropriate (the six additional
(Development criteria are satisfied, including
phase) demonstrating that the website
IV. Content • Creating, purchasing, preparing and will generate probable future
Development uploading information on the website economic benefits for the entity,
(Development before completion of the website’s see Section 11.2.5.2)
phase) development • the cost can be directly
attributed to preparing the
website to operate in the manner
intended by management
Note: Expenditure relating to
developing content to advertise
and promote the entity’s own
products and services is expensed
as incurred.
EXHIBIT 11.4 Development of a website
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Website stage Example activities Accounting treatment
V. Operating • Updating graphics and content Expense as incurred, unless the
(Operating phase) • Adding new functions, features expenditure meets the:
and content • definition of an intangible
• Registering the website with asset; and
search engines • general recognition criteria (refer
• Backing up data to the start of Section 11.2)
• Reviewing access
• Analysing usage of the website
EXHIBIT 11.4 (Continued )
Key Learning Point
Judgement will be necessary to assess whether website development expenditure
relates to advertising and promoting the entity’s goods and services or to generating
direct revenues for the entity. Advertising and promotional expenditure (including digital
photographs of products) is always expensed as incurred even if incurred as part of the
project to build an external website on which online shopping is possible.
11.2.5.5 Internally Generated Goodwill
Internally generated goodwill is not a recognised internally generated intangible asset because
HKAS internally generated goodwill is not an identifiable asset (fails definition) for which a cost can be
38.48–49 measured reliably (fails recognition).
Knowledge Check Questions
Question 3
Great Pics Limited (GPL) acquired distribution rights to the TV series ‘Gotcha!’ for HK$10
million on 1 January 20X1 from Big Boss Limited (BBL). It incurred the following costs:
• GPL head office staff salaries while negotiating the purchase of ‘Gotcha!’ and other
shows – HK$20 million;
• Lawyer fees for drafting the contract with BBL for purchase of ‘Gotcha!’ – HK$1.5 million;
• Fee paid to an agency to add Cantonese subtitles to the TV series, to cater to the
local audience – HK$3 million; and
• Purchase of ads to advertise the future showing of the TV series – HK$1 million
Analyse whether GPL has an intangible asset to recognise, and if so, calculate its initial
measurement.
Question 4
Government A transferred to EDU Limited (EDU) a radio licence for free. The fair value of
the transferred asset is HK$10 million. EDU incurred expenditure of HK$0.1 million to test
that the assigned radio band was working properly.
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Knowledge Check Questions (continued)
Prepare the journal entry to recognise the licence under the two allowable methods
permitted under HKFRS for determining the initial measurement of the granted asset.
Question 5
Insta Flix Limited (IFL) is in the process of producing the documentary ‘Asian Art History’.
To date, it has incurred the following expenses:
• Investigating different documentary concepts – HK$2 million;
• Preparing the pitch for the documentary to IFL management, including a proposed
storyboard, detailed budget for the film and identification of the necessary technical,
financial and other resources – HK$5 million;
• Research and script drafting – HK$10 million;
• Permits for shooting locations – HK$1.5 million;
• Film talent and crew wages – HK$20 million (includes penalties of HK$4 million for
production delays in filming);
• Travel costs to filming locations – HK$6 million; and
• Depreciation of production equipment – HK$3 million.
External funding for the project, equipment and the project team (main actor,
producer, director and writers) was secured by 30 June 20X2 prior to work beginning on
the project. IFL management is confident the documentary will generate future economic
benefits having regard to the prior success of its similar shows produced by the same
project team.
Calculate the cost of the documentary.
Question 6
Monet Limited (Monet) acquires IFL’s ‘Asian Art History’ documentary while it still is in
post-production. Consequently, it recognises a ‘Produced content – post-production’
intangible asset in its financial statements. Monet subsequently spends a further HK$10
million in post-production wages to prepare the documentary to a state where it is ready
to be shown to a public audience.
Identify which of the following describes how the HK$10 million is accounted for in
Monet’s financial statements:
A As an expense in profit or loss because the expenditure is research in nature
B As an expense in profit or loss because the consideration for the acquired documentary
in production will have taken into consideration the further economic outflows required
to complete the project
C As an addition to the recognised asset for the acquired documentary in production because
the expenditure improves the future economic benefits obtainable from the asset
D As an addition to the recognised asset for the acquired documentary in production
because the expenditure is development in nature and directly attributable to creating,
producing and preparing the asset to be capable of operating in the manner intended by
management
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Knowledge Check Questions (continued)
Question 7
In 20X3, Alpha Limited (Alpha) decided to undertake a project to develop an external
website to allow customers to make online purchases. Alpha determined that development
of the website had reached a stage where capitalisation of qualifying expenditures is
appropriate on 1 July 20X3.
Alpha incurred the following expenditures subsequent to 1 July 20X3:
• Annual renewal fee for use of the domain name – HK$100,000;
• Final design of the webpages appearance – HK$2 million;
• Professional photographs of Alpha’s products – HK$3 million;
• Web designer salary to write code to enable the online sales and interact with
operating software – HK$10 million;
• Web designer salary to upload content about the products – HK$0.5 million;
• Web designer salary to upload content providing information about Alpha Limited –
HK$2 million; and
• Backup of website to a remote server on 31 October 20X3 – HK$0.1 million.
The website went live on 30 September 20X3. Calculate the measurement of the
website intangible asset.
1 1 . 3 MEASUREMENT AFTER RECOGNITION
An entity has the choice of adopting as its accounting policy the ‘cost model’ or the ‘revaluation
model’ for the subsequent measurement of an intangible asset. The mechanics of the
models operate in much the same manner as described in Chapter 7 for property, plant
and equipment. Hence, this section does not revisit these in detail. Instead, this section
highlights some subtle important differences between the requirements for the subsequent
measurement of intangible assets and those for property, plant and equipment.
11.3.1 Cost Model
HKAS The cost model requires an intangible asset to be carried at its cost less any accumulated
38.74 amortisation and accumulated impairment losses.
11.3.2 Revaluation Model
Under the revaluation model, recognised intangible assets are subsequently measured at the
HKAS reporting date at an amount that approximate the asset’s fair value at that date. To give effect
38.74 to this, the revaluation model requires an intangible asset to be carried at its:
fair value at the date of revaluation less any subsequent accumulated amortisation less
subsequent accumulated impairment losses.
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The revaluation model does not specify an intangible asset must be revalued to its fair
value at the reporting date. However, the amortised carrying amount of the intangible asset
from the time of its last revaluation must not differ materially from its fair value at reporting
date. This is ordinarily ensured by conducting revaluations of the intangible asset to its fair
value with sufficient regularity.
The revaluation model subtly differs from the fair value models available (or required) for
assets, such as investment property (see Chapter 8) and some financial assets (see Chapter 12).
Those require the asset to be measured at fair value on the reporting date, effectively requiring
a revaluation of the asset as at the reporting date.
Key Learning Point
An intangible asset can be revalued at a date other than the reporting date.
On revaluation, any revaluation increments and decrements are recognised in (non-
recyclable) other comprehensive income or in profit or loss consistent with the application of
the revaluation model to property, plant and equipment (refer to Section 7.4.2 in Chapter 7).
The revaluation model can be applied to an intangible asset for which only part of the costs
HKAS
incurred in developing that asset are capitalised as the intangible asset did not meet the criteria
38.77 for recognition until partway through the process. As the revaluation model applies to the entire
asset, this could have the effect of indirectly ‘capitalising’ those previously expensed costs. The
basis for this is different to and does not contravene the prohibition noted at the start of
Section 11.2, that is, that expensed expenditure cannot be recognised as part of the cost of an
intangible asset at a later time, including in instances when future events prove their recoverability.
11.3.2.1 Differences in Applying the Revaluation Model to Intangible Assets
Compared to Property, Plant and Equipment
Two key differences exist between the operation of the HKAS 38 revaluation model for
intangible assets, and the HKAS 16 revaluation model for property, plant and equipment.
These relate to the determination of fair value and to the measurement of certain assets under
the revaluation model at other than ‘fair value at the date of revaluation less any subsequent
accumulated amortisation less subsequent accumulated impairment losses’.
Determination of Fair Value
Under the revaluation model, an asset is revalued to its fair value. HKFRS 13 Fair Value
Measurement sets out how fair value is measured. Under HKFRS 13, a fair value can be
established even where an active market does not exist (review Chapter 4 if necessary).
HKAS However, for the purposes of applying the revaluation model to intangible assets, HKAS 38
38.75 requires the fair value of an intangible asset to be established by reference to an active market.
No similar limitation of determining an appropriate fair value applies with regards to
revaluations of property, plant and equipment. (Also, no similar limitation applies in relation to
establishing the fair value of an intangible asset acquired as part of a business combination:
see Section 2.2 and Chapter 29.)
HKFRS An active market is a market in which transactions for the asset take place with sufficient
13.App A frequency and volume to provide pricing information on an ongoing basis. HKAS 38 observes
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that an active market doesn’t usually exist for many intangible assets as many assets will be
unique to the entity (for example, the WFY Limited trademarks, secret recipes and brand
HKAS names) and/or bought and sold in infrequent negotiated transactions for which prices are
38.78 publicly unobservable (e.g. the ‘Mushi Mushi’ franchise rights purchased by the WFY Limited).
That is, an exchange market could exist for the intangible asset (relevant to Chapter 29) but
there is insufficient trade for the market to be labelled an active market.
HKAS Some assets for which there could possibly be an active market include transferable taxi
38.78 and fishing licences or production quotas. In some cases, concluding whether an active market
exists can be difficult, requiring the exercise of significant judgement. For example, in the past
in Australia, differences in views existed as to whether an active market existed for intangible
assets, such as water rights, bed rights, and liquor and gaming licences.
The HKAS restriction on revaluations only being performed where there is an active market
for the intangible asset does not affect an entity’s ability to choose to apply the revaluation
model to a class of intangible assets. However, it does affect the measurement applied to
certain intangible assets in that class. This is discussed next.
Application of the Revaluation Model to a Class That Includes Assets for Which There Is
No Active Market
An entity applies the cost model or the revaluation model to an entire class of assets. For
property, plant and equipment, this means that all assets in the class must be revalued
regardless of whether an active market exists if the revaluation model is adopted for that class.
However, this is not the case for intangible assets. HKAS 38 specifies that certain assets in a
‘revaluation model’ class cannot be revalued because there is no active market for the asset.
HKAS
38.72, The subsequent measurement requirements of HKAS 38, including how the revaluation
81–82, 84 model applies to a mixed class of intangible assets are summarised in Exhibit 11.5.
Intangible Assets
Asset Class #A – Cost Model Asset Class #B – Revaluation Model
Asset #A1 Asset #A2 Asset #B1 Asset #B2 Asset #B3
Asset #A1 Asset #A2 Active market Active market No active
measured at cost measured at cost exists ceases to exist market exists
less accumulated less accumulated
amortisation and amortisation and
impairment losses impairment losses Asset #B1 Asset #B2 Asset #B3
measured measured measured
at fair value at the at fair value at at cost less
date of revaluation the date of last accumulated
less any subsequent revaluation by amortisation and
accumulated reference to the impairment losses
amortisation and active market less
accumulated any subsequent
impairment losses accumulated
amortisation and
accumulated
impairment losses
Note: Measurement per revaluation model
(see Asset #B1) restarts once there is an
active market for the asset
EXHIBIT 11.5 Subsequent measurement
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11.3.3 Useful Life
The cost model and the revaluation model refer to reducing the cost or revalued amount of the
intangible asset by any subsequent accumulated amortisation. Therefore, knowing the useful
life of an intangible asset is necessary to determine the accumulated amortisation amount, as
amortisation (like depreciation) is the systematic allocation of the depreciable amount of the
intangible asset over its useful life.
The useful life of an intangible asset is the period over which the asset is expected to be
available for use by the entity or the number of production or similar units expected to be
obtained from the asset by the entity. The useful life of an intangible asset is either finite or
indefinite.
The useful life of an intangible asset is:
• Identified as indefinite only when, based on an analysis of all the relevant factors, there
is no foreseeable limit to the period over which the asset is expected to generate net
cash flows for the entity; and
HKAS • Determined having regard to the asset controlled by the entity, not the asset that the
38.8, 88, 91 entity would like to control.
HKAS An intangible asset is amortised over its finite useful life. An intangible asset that has an
38.88 indefinite useful life is not amortised.
Determining the useful life of an intangible asset is subject to judgement, and it can be
challenging in practice to estimate a useful life that is neutral to faithfully represent the
substance of the asset. A neutral depiction is one that is without bias in the selection or
HKAS presentation of financial information; for example, though prudency may be observed, the
38.93 useful life of an intangible asset should not be unrealistically short. Factors considered when
determining the useful life of an intangible asset include:
• How the asset is expected to be used by the entity and if the asset could be managed
efficiently by another management team;
• Typical product life cycles for the asset as well as public information on estimates of
useful lives of similar assets that are used in a similar way;
• Technical, technological, commercial or other types of obsolescence (for example,
obsolescence could be indicated by expected future reductions in the selling price of an
item that was produced using the intangible asset);
• The stability of the industry in which the asset operates and changes in the market
demand for the products or services output from the asset;
• Expected actions of competitors or potential competitors;
• The level of maintenance expenditure required to obtain the expected future economic
benefits from the asset and the entity’s ability and intention to reach such a level;
• The period of control over the asset and legal or similar limits on the use of the asset,
such as the expiry dates of related leases; and
HKAS
38.90, 92 • The dependency on the useful life of other assets of the entity.
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As established in Section 11.1.2.3, an intangible asset arises from contractual-legal rights
or because it is separable from the entity. The useful life of an intangible asset that arises
from contractual or other legal rights is no longer than the period of the contractual or legal
rights but is shorter if the entity expects to use the asset for a shorter period. For example, if
an acquired copyright held by WFY Limited had a remaining legal life of 20 years but there is
evidence (e.g. market behaviour and trends) to indicate that the copyrighted material will only
generate cash flows for another eight years, an appropriate useful life of the copyright is no
longer than eight years.
In addition, similar to how the useful life of a right-to-use asset under lease can be a lease
term that includes a renewal period (see Chapter 9), the period of the contractual or legal right
includes a renewal period when there is evidence to support renewal of the right by the entity
without significant cost. This is demonstrated by the existence of factors, such as:
• Evidence that the right will be renewed (e.g. WFY Limited’s history may indicate it always
renews its trademarks and the government approves all trademark renewals as a
matter of course);
• Evidence that any conditions necessary to obtain renewal will be satisfied (e.g.
continuing to have the right to use the brand name protected by the trademark); and
• The cost of renewal is not significant when compared with the future economic benefits
expected to flow to the entity from renewal (e.g. if paying a HK$2,670 renewal fee for
HKAS the trademark is expected to enable WFY to generate revenues of many times that
38.94, 96 amount to its stores).
HKAS The useful life of a recognised reacquired right (a contractual-legal intangible asset) does
38.94 not include any renewal periods. Section 29.5.3 of Chapter 29 explains why.
An entity reviews its useful life assessments at least at the end of each reporting period.
This may result in a change in the entity’s assessment whether the useful life of an intangible
asset is finite or indefinite or may result in a change in the period over which amortisation
HKAS should occur. Both changes are treated as a change in accounting estimate (refer to
38.104, 109 Chapter 16).
11.3.4 Amortisation
As noted in Section 11.3.2, an intangible asset that has a finite useful life is amortised. Like
property, plant and equipment, the depreciable amount of the intangible asset is allocated on
a systematic basis over its useful life in a manner that reflects the pattern in which the asset’s
future economic benefits are expected to be realised by the entity.
Amortisation is charged to profit or loss unless it qualifies for capitalisation as part of
another asset. It begins when the asset is in the condition and location necessary for it to
be capable of operating in the manner intended by management and ends at the earlier of
the date the asset is classified as held for sale and the date the asset is derecognised.
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Refer to Section 7.4.4 of Chapter 7 to review possible different systematic bases, identify
HKAS how an entity selects an appropriate basis over which to amortise the asset, and understand
38.97 how to calculate the periodic charge.
Of note, however, particular to intangible assets is the following:
• The residual value of an intangible asset is assumed to be zero, except where it can be
demonstrated otherwise (see below).
• If the pattern of consumption of an intangible asset cannot be determined reliably, the
HKAS straight-line method must be used to allocate the depreciable amount of the asset.
38.97 HKAS 16 is not as explicitly restrictive in this regard for property, plant and equipment.
• Generally, as for property, plant and equipment, it will be inappropriate to apply an
amortisation method based on the revenue generated by an activity that includes the
use of the intangible asset. However, it is possible for this presumption to be rebutted
HKAS for intangible assets. HKAS 16 does not permit the use of such a method for property,
16.62A plant and equipment in any circumstance.
An amortisation method based on the revenue generated by an activity that includes the
use of the intangible asset can be used – where determined to be that that most closely reflects
the expected pattern of consumption of the intangible asset – only in the following limited
circumstances:
• When the intangible asset is expressed as a measure of revenue, that is, where the
predominant limiting factor is the achievement of a revenue threshold. This can be
analogised to a units-of-production method. For example, the operator of a road has
the right to toll the road only until tolls collected reach an agreed amount; or
HKAS • When it can be demonstrated that revenue and the consumption of the economic
38.98A–C benefits of the intangible asset are highly correlated.
The residual value of an intangible asset with a finite useful life is assumed to be zero
unless one of the following conditions is met:
• A third party has contractually committed to buy the asset at the end of its useful life;
• There is an active market for the asset:
°° The market provides sufficient information to indicate what the residual value
will be; and
HKAS
38.100
°° It is probable that the market will exist at the end of the asset’s useful life.
HKAS A residual value other than zero implies that the intangible asset will be disposed by the
38.101 entity before the end of its economic life, that is, its useful life is shorter than its economic life.
Like the intangible asset’s useful life, an entity must review the residual value estimate and
amortisation method at least at the end of each annual reporting period. Any changes are
HKAS
38.102, 104 treated as a change in accounting estimate (refer to Chapter 16).
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Key Learning Point
Intangible assets are subsequently accounted for in the same manner as property, plant
and equipment; however, there are two application differences:
1. What assets can be revalued under the revaluation basis (property, plant and
equipment – all; intangible assets – only those for which there is an active market).
2. Whether a depreciation/amortisation method based on the revenue generated by
an activity that includes the use of the asset can be employed (property, plant and
equipment – never; intangible assets – in limited situations).
Apply and Analyse 3
In 20X0, WFY Limited acquired the rights to operate ‘Mushi Mushi’ shops in Hong Kong for
a period of 10 years for HK$10 million. At the end of the contractual term, the rights revert
back to the franchisor for nil consideration.
Determine an appropriate accounting policy for amortisation of the franchise rights.
Analysis
Having regard to the nature of franchise rights, the consumption of the rights is not
affected by the number of franchise sites WFY Limited operates (although this impacts
its return on the investment) or revenue generated from the sites. Also, though the
popularity of the franchise might diminish over time suggesting that WFY Limited’s return
on its investment may reduce over time, the popularity of the franchise might hold or
strengthen.
WFY Limited concludes there is no indication the rights have an alternate pattern
of consumption that is more reliably determinable than WFY Limited realising the
economic benefits of the franchise rights equally over the contract term. Consequently,
WFY Limited management should employ the straight-line method to amortise the
franchise rights intangible asset as this is the basis that most closely reflects the
pattern in which the asset’s future economic benefits are expected to be realised by
the entity.
The depreciable amount of the asset is HK$10 million. The asset has no value to
WFY Limited at the end of the contract period as it reverts to the franchisor for free
(residual value = 0). Accordingly, under the straight-line method, WFY recognises annual
amortisation expense of HK$1 million, calculated as:
Depreciable amount (HK$10 million) / Useful life (10 years) HK$1 million
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Apply and Analyse 4
On 1 January 20X1, WFY Limited recognised an acquired trademark at HK$3 million. The
trademark is renewable with the relevant authority for a nominal fee in three years’ time.
There is no restriction on the number of times the registration can be renewed.
To alleviate financial difficulties, WFY Limited plans to stop operating the business
to which the trademark relates in two years’ time and has begun winding down
the operations. Management is also considering seeking a buyer for the business.
Management anticipates that the trademark will continue to have a value of at least
HK$1 million if it can sell the business.
WFY Limited’s accounting policy is to measure the trademark using the cost
model. Management has determined that the trademark should be amortised on a
straight-line basis.
Calculate the amortisation expense for the financial year ended 31 December 20X1.
Analysis
To determine the amortisation expense, the depreciable amount of the asset must
be determined. The depreciable amount is its cost (HK$3 million) also known as the
residual value.
The residual value of the asset is HK$nil at reporting date 31 December 20X1 because
neither of the conditions to use a different residual value are met as there is no active
market for the trademark because the trademark is unique and WFY Limited is not
contractually committed with a third party to sell the trademark.
As such, the depreciable amount of the asset is HK$3 million.
The depreciable amount is allocated over the asset’s useful life if there is a finite
useful life, the annual charge being the amortisation expense for the period. WFY Limited
determines that the useful life of the trademark is not indefinite but finite; even though the
trademark can be renewed infinitely at no significant cost, the evidence suggests that WFY
Limited will not renew the trademark as its plan is to sell it before the renewal date. WFY
Limited determines the trademark’s useful life to be two years as it intends to only use the
contractual-legal intangible asset for two years before disposing it.
Having regard to the nature of a trademark, WFY Limited concludes the straight-
line method is the basis that most closely reflects the pattern in which the asset’s
future economic benefits are expected to be realised by the entity. As such, it uses
the straight-line method to calculate the allocation of the depreciable amount (the
amortisation expense) for the period.
Under the straight-line method, WFY Limited recognises an annual amortisation
expense of HK$1.5 million (HK$3 million/2 years). The carrying amount of the intangible
asset at 31 December 20X1 is HK$1.5 million.
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Knowledge Check Questions
Question 8
Describe the two scenarios where a revaluation may not be able to be completed for an
asset within a class of assets measured using the revaluation model. Identify the how
those assets are measured.
Question 9
On 1 January 20X1, Fern Limited (Fern) recognised an acquired food licence at HK$3 million.
The licence is renewable with the relevant authority for a nominal fee in three years. There
is no restriction on the number of times the licence can be renewed.
A food licence is unique to the business it covers and cannot be transferred to another
business. In Fern’s jurisdiction, the number of licences issued is capped by the relevant
authority.
Fern plans to sell the business to which the licence relates and to sell the licence within
the next 24 months. Management anticipates that the licence will be valued at least at
HK$1 million at the time of sale. If it cannot find a suitable buyer, Fern will continue to
operate the business.
Fern’s accounting policy is to measure all licences using the revaluation model. As of
31 December 20X1, a valuer estimates the licence’s fair value as HK$2.2 million.
Calculate the carrying amount of the food licence as of 31 December 20X1.
1 1 . 4 RETIREMENTS AND DISPOSALS
HKAS An intangible asset is derecognised on disposal or when no future economic benefits are
38.112 expected from its use or disposal.
The gain or loss arising on derecognition is calculated and accounted for in the same
manner as for property, plant and equipment as described in Chapter 7. Review Section 5 of
HKAS Chapter 7 to refresh your understanding of the accounting in this regard, including where the
38.113 gain is recognised and how any revaluation surplus is treated.
Knowledge Check Question
Question 10
HHA Limited (HHA) sells film distribution rights to Big Boss Limited (BBL) on 30 June 20X4
for cash for HK$50 million plus 0.1% of the revenue from the sales of BBL’s Product A
between 1 July 20X4 and 30 June 20X9. A valuer has estimated the expected value of the
future consideration receivable to be HK$40 million.
At the time of sale, the carrying amount of the film distribution rights was HK$20 million.
Prepare the journal entry on 30 June 20X4 to recognise the gain or loss on sale.
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1 1 . 5 DISCLOSURE
Similar to property, plant and equipment, intangible assets can form a significant part of
an entity’s assets, and their amortisation often be a significant periodic expense. Therefore,
information about an entity’s recognised intangible assets is often important to users of
financial statements in making resource allocation decisions about an entity.
HKAS 38 requires information about the amounts of intangible assets and the accounting
judgements applied to them to be disclosed. In the main, the HKAS 38 general quantitative
disclosures are similar to the information specified by HKAS 16 in relation to property, plant
and equipment, being to disclose, by class of intangible asset:
• A reconciliation of the carrying amount at the beginning and end of the period;
• The measurement basis (cost model or revaluation model);
• The amortisation methods used;
• The useful lives or the amortisation rates used;
• Amortisation for the period;
• Accumulated amortisation;
• The gross carrying amount and the accumulated amortisation (aggregated with
accumulated impairment losses) at the beginning and end of the period;
• For revalued intangible assets, the effective date of the revaluation and the carrying
amount of that class of intangible assets; and
HKAS • For revalued intangible assets, the carrying amount that would have been recognised
38.118, 124 had the assets been carried under the cost model.
Refer to Section 7.6 of Chapter 7 for examples.
The above disclosures by class of intangible asset must conform to the following principles:
• Internally generated assets are distinguished from other intangible assets; and
HKAS • Intangible assets measured on the cost model are not aggregated together with intangible
38.118,125 assets measured on the revaluation model into a single class of intangible assets.
HKAS 38 also requires disclosure of additional information about certain intangible assets
held, as summarised in the following:
• Any individual intangible asset that is material to the entity’s financial statements – a
description of the intangible asset, its carrying amount and remaining amortisation period;
• Intangible assets assessed as having an indefinite useful life – the carrying amounts and
HKAS reasons supporting the assessment of an indefinite useful life. In giving its reasons, the
38.122 entity describes the factors that played a significant role in making this determination;
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• Intangible assets acquired by way of a government grant that have been initially
recognised at fair value – the carrying amount, the initial fair value measurement and
the measurement model adopted;
• Intangible assets whose title is restricted – the existence of the intangible asset and its
carrying amount;
• Intangible assets that have been pledged as security for liabilities – the carrying amount
of those intangible assets; and
• The amount of contractual commitments for the acquisition of intangible assets.
Illustrative Example 3
WFY Limited has assessed Brand ‘Yum’ and liquor licences held to have indefinite useful
lives. It makes the following disclosure in its general-purpose financial statements
to comply with the requirement in HKAS 38 to explain the reasons supporting its
assessment that the assets have an indefinite life:
Accounting Policies: Intangible Assets (Extract)
Assets with an assumed indefinite useful life are reviewed at each reporting period to
determine whether this assumption continues to be appropriate. If not, it is changed to a
finite life and accounted for prospectively as a change in accounting estimate.
Key judgement: useful lives of intangible assets
Brand ‘Yum’ has been assessed as having an indefinite life based on strong brand
strength, ongoing expected profitability and continuing support. The brand incorporates
complementary assets, such as store formats, networks and product offerings.
Liquor licences have been assessed as having indefinite lives based on the licences
being expected to be renewed in line with business continuity requirements.
The disclosure also complies with the requirement in HKAS 1 Presentation of Financial
Statements to disclose the entity’s key judgements.
Illustrative Example 4
EDU Limited (EDU) was granted a radio licence by Government A for free, which it
initially measured at fair value of HK$10 million plus associated directly attributable
costs of HK$0.1 million. EDU might make the following disclosures to comply with
the requirements in HKAS 38 to disclose information about (i) material intangible
assets, (ii) intangible assets acquired by way of a government grant, which are initially
recognised at fair value; and (iii) intangible assets subject to restrictions.
Radio Licence (Measured on the Cost Basis)
EDU was granted a radio licence in 20X0 from Government A. The licence (20X1: carrying
amount of HK$8.08 million) is material to EDU’s operations as it enables EDU to conduct
its principal activity of delivering radio broadcasts to the community as well as being one
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Illustrative Example 4 (continued)
of EDU’s main channels of raising revenues through sponsorship and ad placements. The
licence was initially measured at its fair value of HK$10 million, plus directly attributable
costs of HK$0.1 million, and will be amortised on a straight-line basis over its five-year
grant period.
Under the terms of the grant, the licence is not transferable to another entity.
Consistent with the objective of general-purpose financial reporting being to provide
useful information to primary users of its financial statements, entities are encouraged to also
disclose to users a description of:
• Any fully amortised intangible asset still in use;
• Significant intangible assets controlled by the entity but not recognised as assets
because they did not meet the recognition criteria; and
• Significant intangible assets controlled by the entity but not recognised as assets
HKAS because they were acquired or generated before the version of SSAP 29 Intangible
38.128 Assets issued in 2001 became effective.
Other HKFRSs also specify disclosures of intangible assets; for example, HKAS 8 Accounting
Policies, Changes in Accounting Estimates and Errors requires disclosures to be made on a change
in the useful life assessment affecting the periodic amortisation expense (see Chapter 16) and
HKFRS 3 (Revised) Business Combinations sets out specific disclosures for acquired goodwill
arising in a business combination:
• The line item(s) of the statement of comprehensive income in which amortisation is
HKAS included. (This disclosure could be more complicated to make where an ‘expenses by
38.118(d) function’ approach is adopted);
HKAS • The aggregate amount of research and development expenditure recognised as an
38.126 expense during the period; and
• The opening and closing revaluation surplus relating to intangible assets, showing
the change for the period and any restrictions on the distribution of the balance to
shareholders.
Knowledge Check Questions
Question 11
Identify which one of the following statements is correct.
A HKAS 38 requires disclosures about an entity’s intangible assets, with disclosures being
made on an asset by asset basis.
B Disclosures about the useful lives of intangible assets are required, including why an
asset has been determined to have a finite useful life.
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Knowledge Check Questions (continued)
C Specific disclosures are required for intangible assets measured using the cost
model, including disclosure of the assumptions used in estimating the fair value of an
intangible asset.
D Disclosures must be made separately for internally generated intangible assets and
other intangible assets.
Question 12
Identify which one of the following disclosures is not required for intangible assets
measured after recognition using the revaluation model
A By class of intangible asset, the carrying amount of revalued intangible assets as though
the assets had been measured using the cost model
B By class of intangible asset, the effective date of the revaluation or a statement that the
assets have not been revalued
C The amount of the revaluation surplus that relates to intangible assets at the beginning
and end of the period
D By class of intangible asset, the amortisation recognised during the period
1 1 . 6 CURRENT DEVELOPMENTS
The International Accounting Standards Board (IASB) is currently undertaking a research
project exploring possible improvements to the accounting for acquired goodwill in response
to feedback that the information provided in financial statements about goodwill is insufficient
and that impairment of goodwill is not recognised in a timely fashion and is costly and complex
to determine. The IASB also received feedback that recognising and measuring some intangible
assets separately from goodwill is challenging. In March 2020 the IASB issued a Discussion
Paper – Business Combinations – Disclosures, Goodwill and Impairment setting out its preliminary
views that certain measurement improvements and simplifications and certain disclosure
improvements should be developed but that no changes to the underlying accounting
requirements for goodwill and intangible assets should be proposed.
The IASB is currently discussing feedback on the Discussion Paper. At this stage, any
potential changes to IFRSs and to HKFRSs remain unknown.
Though the ‘Goodwill and Impairment’ project is the only currently active project on the
IASB’s workplan, the accounting for intangible assets is an area that should be monitored
for developments because the adequacy of the existing accounting requirements continues
to be tested by the introduction of new forms of intangible assets. For example, in 2019, the
IASB’s IFRS Interpretations Committee issued two agenda decisions in response to requests
to consider whether a digital currency and a right to access cloud-hosted application software
were intangible assets within the scope of HKAS 38.
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SUMMARY
• An intangible asset is an identifiable, non-monetary asset without physical substance.
• An asset is identifiable if it is separable from the entity or it arises from contractual or other
legal rights.
• An intangible asset is recognised only when the expected future economic benefits
attributable to the asset will probably flow to the entity, and the cost of the asset can
be measured reliably. Additional recognition criteria apply to internally generated
intangible assets.
• Recognised intangible assets are measured initially at cost, determined as follows:
°° Separately acquired intangible assets – the sum of the purchase price and any directly
attributable costs of preparing the asset for its intended;
°° Identifiable intangible assets acquired in a business combination – the fair value of the
intangible asset at the acquisition date;
°° Intangible assets acquired by way of a government grant – following the treatment of the
grant at fair value or at a nominal amount plus any directly attributable costs;
°° Intangible assets acquired through an exchange of assets – following a specified hierarchy
at fair value or at the carrying amount of the asset given up; and
°° Internally-generated intangible assets – the sum of the directly attributable costs necessary
to create, produce and prepare the asset to be capable of operating in the manner
intended by management.
• Internal projects that may generate an intangible asset must be classified into research and
development phases.
°° Costs incurred in the research phase do not meet the recognition criteria and
are expensed.
°° Costs incurred in the development phase are capitalised as part of the cost of the intangible
asset if incurred after the recognition tests are met.
• Expenditure incurred to develop a website that solely or primarily promotes and advertises
the entity’s own products and services is expensed as incurred.
• Some internally generated intangible assets cannot be recognised, for example, brand,
mastheads, publishing titles, customer lists and items similar in substance.
• An internally generated intangible asset that is not recognised by the acquiree may be
recognisable by the acquirer in a business combination.
• Intangible assets are subsequently measured using the cost model or the revaluation model.
°° Cost model – cost less any accumulated amortisation and accumulated impairment losses.
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°° Revaluation model – fair value at the date of revaluation less any subsequent accumulated
amortisation and accumulated impairment losses.
• Amortisation is charged over an asset’s useful life, beginning when the asset is in the
condition and location necessary for it to be capable of operating in the manner intended
by management. The useful life of an intangible asset is finite or indefinite. Indefinite life
intangible assets are not amortised.
• The residual value of an intangible asset is assumed to be zero except in certain
circumstances.
• An intangible asset is derecognised on disposal or when no future economic benefits are
expected from its use or disposal. The gain or loss on disposal is recognised and measured
consistent with the treatment of disposals of property, plant and equipment.
• Disclosures include a detailed reconciliation by class of intangible asset and information
about certain intangible assets, including those intangible assets measured using the
revaluation model.
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MIND MAP
DEFINITION AND SCOPE RECOGNITION AND INITIAL
MEASUREMENT – GENERAL
Identifiable non-monetary asset without
physical substance Recognition criteria: (i) probable future
• Identifiable when Separable or economic benefits (ii) reliably measurable
Contractual-Legal cost
• Non-monetary = not money or a right to Initial measurement at cost. Depending on
receive monies the circumstance, cost determined
• Entity must be able to demonstrate • As purchase price + directly attributable
control of a resource: Difficult to show costs
when enforceable legal right not present • By reference to a fair value
• No physical substance: Judgement required • By reference to the carrying amount of
for assets that include a tangible element the asset given up in exchange
HKAS 38 scope exclusions include: • As nominal amount + directly attributable
• Goodwill arising in a business combination costs
(Chapter 29)
• Intangible assets that are inventory RECOGNITION AND INITIAL
(Chapter 6) MEASUREMENT – INTERNALLY
• [choice] Leases of intangible assets other INTANGIBLE ASSETS GENERATED INTANGIBLE ASSETS
than licences for items such as films, video (HKAS 38) Initial measurement at cost
recordings, plays, manuscripts, patents and
Six additional recognition criteria for
copyrights (Chapter 9)
recognition. Criteria shows asset:
• Intangible assets held for sale (Chapter 15)
• Will be completed AND will generate future
economic benefits for the entity
DISCLOSURE
• Can be reliably measured
Required Research phase costs – always fails
• Reconciliation recognition => expensed
• General information about accounting
Development phase costs – capitalise
policies, estimates and key judgements
directly attributable costs incurred after
• Details about revaluations
recognition criteria are met
• Information about specific intangible assets,
for example, material intangible assets, Recognition criteria might be met only
restrictions, contractual commitments for partway during development phase
intangible assets Certain intangible items are not recognisable
Encouraged • Brands, mastheads publishing titles,
• Description of fully amortised intangible customer lists and similar items
assets still in use • Internally generated goodwill
• Description of significant intangible assets
SUBSEQUENT MEASUREMENT
controlled by the entity but not recognised
as assets Cost model or Revaluation model
• No active market: Modified measurement for certain assets in
‘revaluation model’ class
Recognition of amortisation expense, revaluation gains and losses in
profit or loss or OCI – same rules as for PPE
Useful life is finite or indefinite
Indefinite life intangible assets are not amortised
Residual value = zero, except where either (i) third party has
committed to buy the intangible asset at end of the asset useful life;
or (ii) active market probably exists at end of the asset useful life
and from which a residual value is estimable
Derecognise on disposal or when no more benefits are expected
Gain/loss on disposal = net proceeds on disposal – carrying amount
Answers to Knowledge Check Questions
Question 1
Answer A is incorrect. An internally generated customer list is an identifiable asset as the
entity could benefit from separately selling that customer list to another party. (However,
as discussed in Section 11.2.5.2, not all identifiable assets are recognisable.)
Answer B is incorrect. An entity’s right to royalties is an asset because the right
contractually entitles the entity to (i.e. the entity has control over) future economic
benefits in the form of royalty revenues from use of the underlying asset. The asset is an
identifiable asset as it is capable of being separated from the entity and the royalty rights
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assigned over to another party. The asset is also identifiable because the asset arises from
a contractual right given by the royalty agreement.
Answer C is incorrect. A gaming licence enables the entity to obtain future economic
benefits in the form of gaming revenues. The asset is identifiable as it is arises from
contractual or other legal rights between the grantor and the entity. The asset is
identifiable even if the entity is restricted from selling or transferring use of that asset to
another entity.
Answer D is correct. An organised workforce is not an asset as it does not satisfy the
control test because the entity has insufficient control over the future economic benefits
arising from the workforce. The employees can leave the entity at any time or not execute
their role in a manner to generate future economic benefits for the entity. Further, an
organised workforce is not usually separable from the entity.
Question 2
IFL’s rights to TV shows and other programmes it produces (i.e. internally develops) meet
the definition of an intangible asset as:
• an asset – IFL has control over the TV shows and other programmes as it has
ownership rights through producing the shows. IFL expects the programmes to
generate future revenues for the entity as otherwise it would not have developed
them. That is, the rights to the TV shows and other programmes are IFL assets.
• without physical substance – the TV shows and other programmes do not have a
physical substance. However, some shows that are shot on film rather than using
digital cinematography will have a physical substance as the ‘content’ (the show) is
saved on the tangible film. This physical substance is secondary to the substance of
the asset and therefore the shows continue to be assessed as not having a physical
substance.
• non-monetary – the TV shows and other programmes are not money (i.e. cash) and
do not give IFL a right to receive a fixed or determinable number of units of currency.
As such, the assets are non-monetary in nature.
• identifiable – IFL’s rights to the TV shows and other programmes are legal rights. The
TV shows and other programmes are also capable of being separated from IFL and
sold or transferred individually, consistent with the nature of such owned assets.
Therefore, the IFL produced TV shows and other programmes are identifiable assets.
IFL’s rights to TV shows and other programmes it licences from others also meet the
definition of an intangible asset as:
• an asset – IFL controls the right for its subscribers to access the licenced TV shows
and other programmes. IFL expects the programmes to generate future revenues
for the entity as otherwise it would not have licenced them. That is, the rights to the
licenced TV shows and other programmes are IFL assets.
• without physical substance – the rights to the TV shows and other programmes do
not have a physical substance.
• non-monetary – the licenced TV shows and other programmes are not money (i.e.
cash) and do not give IFL a right to receive a fixed or determinable number of units
of currency. As such, the assets are non-monetary in nature.
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• identifiable – the rights to the licenced TV shows and other programmes arise from
contractual rights. It is unlikely they can be being separated from IFL and sold or
transferred individually. (This information has not been provided in the case.)
On review of intangible assets within the scope of HKAS 38, IFL would account for
the produced and licenced TV shows and other programmes in accordance with HKAS 38
because rights held by a lessee under licensing agreements for items, such as films and
recordings, are treated as intangible assets under HKAS 38 rather than as right-to-use
assets under HKFRS 16.
Question 3
The distribution rights are an intangible asset as the rights are non-physical and non-
monetary in nature and arise from a contract entitling GPL to show and obtain any
expected future economic benefits from showing the TV series, for example, in the form of
advertising revenues from ads sold to air while the TV show is being aired. The rights meet
the criteria for recognition as:
• Future economic benefits are probable, as otherwise GPL would not have acquired
the asset; and
• Its cost can be reliably measured as it is given by the sum of its purchase price
(HK$10 million) plus any directly attributable costs necessary to prepare the asset for
its intended use (lawyer fees HK$1.5 million + addition of subtitles HK$3 million).
GPL initially recognises the distribution rights at its cost of HK$14.5 million.
The advertising costs (costs of introducing a new product) and head office staff salaries
(administration and other general overhead cost) do not form part of the cost of the intangible
asset. These costs are expensed as they cannot be directly attributable to the intangible asset.
Question 4
Dependent on the measurement applied to the grant, the licence may be measured at its
fair value at the date of grant or at a nominal amount plus any directly attributable costs of
preparing the asset for its intended use.
Journal entry if the grant and licence were measured at fair value:
Debit Credit
HK$m HK$m
Licence 10
Government grant income 10
Journal entry if the grant was measured at a nominal amount:
Debit Credit
HK$m HK$m
Licence 0.1
Government grant income (cost of transfer) 0
Trade payable/Cash (testing fee) 0.1
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The fee paid to test that the assigned radio band was working properly is a directly
attributable cost of preparing the asset for its intended use and, as such, forms part of the
cost of the asset.
Question 5
Having regard to the nature of the activities, IFL classifies the activities into research and
development phases as follows:
Research: Development:
• Investigating different • Research and script drafting
documentary concepts • Permits for shooting locations
• Preparing the pitch for the documentary to • Film talent and crew salaries
IFL management, including the storyboard,
• Travel costs to filming locations
budget for the film and necessary resources
• Depreciation of production equipment
In accordance with HKAS 38, expenditure incurred in the research phase is expensed
as incurred:
HK$2 million HK$5 million HK$7 million
In accordance with HKAS 38, expenditure on development can be capitalised:
• Once the development is to a stage where the six additional recognition criteria are
met. Here, it is likely the criteria are met by 30 June 20X2, following the securing of
the project funding and project team; and
• Where the expenditure is directly attributable to creating, producing and preparing
the asset to be capable of operating in the manner intended by management.
All of the identified development expenditures post 30 June 20X2 other than the wage
penalties are directly attributable to creating, producing and preparing the documentary
to be capable of operating in the manner intended by management (i.e. aired as a
programme). So, the cost of the in-process intangible asset is:
HK$10 million (storyboarding et al.) + HK$1.5 million (permits) + HK$16 million (salaries) +
HK$6 million (travel costs) + HK$3 million (equipment depreciation)s = HK$36.5 million.
The identified inefficiency (wage penalties) is not included as part of the cost of the
asset as it is not necessary to preparing the asset to be capable of operating in the manner
intended by management.
Question 6
Answer A is incorrect. Post-production activities are development phase activities as they
are part of the end process of the preparing the product for market. As such, the wages
are not incurred in conducting research activities.
Answer B is incorrect. Though the price paid for the acquired IPR&D may have taken
into consideration the further economic outflows required to complete the project, this
does not negate the acquirer’s ability to recognise the further spending as an asset in
accordance with HKAS 38.
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Answer C is incorrect. In accordance with HKAS 38, the expenditure must be considered
for recognition as an in-progress internally generated intangible asset, rather than having
regard to whether it represents a capitalisable improvement to a completed asset.
Answer D is correct. Post-acquisition expenditure on acquired IPR&D is treated as
the appropriate of research or development until the asset able to operate in the
manner intended by management. The wages paid for post-production work is a part
of development and is directly attributable to and necessary to bring the asset to a
stage where it can operate in the manner intended by management. Therefore, it is
appropriately included as part of the cost of the intangible asset.
Question 7
The website will not be used solely or primarily to promote or advertise Alpha’s products
and services but to provide another avenue for the entity to generate revenues
through online sales. Therefore, in accordance with HKAS 38 and HK(SIC)-Int 32,
qualifying development expenditure can be capitalised as part of the cost of a ‘website’
intangible asset.
As Alpha has determined that, by 1 July 20X3, the project has reached a stage where
completion is technically and commercially viable, it can capitalise expenditure incurred
post this time where the expenditure is directly attributable to the intangible asset and
necessary to create, produce or prepare the asset so it is capable of operating in the
manner intended by management. On review of the various expenditures, the following
are directly attributable to creating the website that will enable online sales to take place:
• Final design of the web pages appearance – HK$2 million;
• Web designer salary to write code to enable the online sales and interact with
operating software – HK$10 million; and
• Web designer salary to upload content about the products – HK$0.5 million.
Hence, the cost of the website is HK$12.5 million.
Rationales for not capitalising the remaining expenditures:
• Annual renewal fee for use of the domain name (HK$100,000) – this cost is a part
of maintenance expenditure and, hence, cannot be capitalised. The initial fee to
acquire the domain name might qualify to be capitalised if incurred subsequent
to the time the project had reached a stage where completion is technically and
commercially viable.
• Professional photographs of Alpha’s products (HK$3 million) – in accordance with
HK(SIC)-Int 32, these costs are considered to be a part of advertising and promotional
expenditure, rather than necessarily incurred to generate direct revenues for Alpha.
Advertising costs are expensed as incurred.
• Web designer salary to upload content providing information about Alpha Limited
(HK$2 million) – although incurred in the development phase, the salary relates to
work performed to advertise the entity rather than to being directly attributable
to preparing the website to generate revenues. Hence, the costs are expensed
as incurred.
• Backup of website to a remote server on 31 October 20X3 (HK$0.1 million) – this
cost was incurred after the website had begun operating in the manner intended
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by management (i.e. incurred during the operating phase). Hence, the cost cannot
be capitalised unless it meets the definition of an intangible asset and the general
recognition criteria. As the future economic benefits from the underlying resource
(benefit of backup data) are not separable from the entity, the cost cannot be
capitalised but is expensed as incurred.
Question 8
The two scenarios where an asset in a class may not be able to be revalued are the
following:
1. Where there is no active market ever available for that asset. In this case, the asset
is carried at its cost less any accumulated amortisation and impairment losses.
2. Where an active market no longer exists for the asset. In this case, the asset is
measured at the most recent revalued amount less any subsequent accumulated
amortisation and impairment losses.
Question 9
The carrying amount of the licence at 31 December 20X1 is HK$3 million.
Even though the licence is in a class measured by using the revaluation model, in
accordance with HKAS 38, the licence must be measured at its cost (HK$3 million) less
accumulated amortisation (HK$nil) and impairment as there is no active market for the
asset. There is no active market for the licence as it is unique to the business and not
traded separately from the sale of the business.
The accumulated amortisation is nil because the asset is assessed to have an indefinite
useful life and, therefore, is not amortised because Fern will continue to operate the
business if it cannot find a suitable buyer, which provides evidence that Fern will need
to renew the licence. There is no indication that Fern will not be able to comply with any
conditions necessary to obtain the renewal, and the cost of the renewal is insignificant when
compared with the future economic benefits expected to flow to the entity from renewal.
A fair value can be determined even though no active market exists. This does not
mean it is an appropriate fair value for the purposes of applying the revaluation model.
However, if the case facts had been that the Fern is selling the licence and the other
conditions necessary for the intangible asset to be classified as held for sale are met, Fern
would measure the licence at fair value less costs to sell in accordance with HKFRS 5. The
fair value measurement of HK$2.2 million would be relevant in this case.
Question 10
HHA recognises the following journal entry:
Debit Credit
HK$m HK$m
Cash 50
Contingent consideration receivable 40
Film distribution rights 20
Gain on sale of film distribution rights (other income) 70
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The gain on sale is calculated as the difference between the net proceeds on
disposal (HK$90 million; see below) and the carrying amount of the asset at that time
(HK$20 million).
The net proceeds on disposal are determined as the amount of consideration to which
an entity expects to be entitled in exchange for transferring the promised goods, excluding
amounts collected on behalf of third parties, measured in accordance with HKFRS 15 (see
Chapter 5). This is the fixed consideration of HK$50 million + variable consideration of
HK$40 million.
A further gain (or reversal of gains previously recognised) is recognised as the variable
consideration estimate changes until the uncertainty is resolved (i.e. until 30 June 20X9).
Review Chapter 5 to refresh your understanding of why this is the accounting treatment.
Question 11
Answer A is incorrect. Basically, HKAS 38 requires disclosure by class of asset,
distinguishing between internally generated intangible assets and other intangible assets.
Answer B is incorrect. Disclosures are required about the useful lives of the intangible
assets held. These disclosures include the reasons supporting an entity’s assessment of
why the useful life of an intangible asset has been determined as indefinite and, where the
entity has determined the useful life of an intangible asset to be finite – that useful life and
the amortisation rates used. Disclosure of the reasons the entity has determined a finite
life is appropriate is not an HKAS 38-specified disclosure (but this may be disclosed if it is
material information).
Answer C is incorrect. Disclosure of the fair value of intangible assets measured using the
cost model is not required. This differs from property, plant and equipment, the disclosure
of which is encouraged to be measured using the cost model. Also, HKAS 38 does not
specify any disclosures ‘specifically’ applying only to intangible assets measured using the
cost model.
Answer D is correct. Basically, HKAS 38 requires disclosure by class of asset, distinguishing
between internally generated intangible assets and other intangible assets
Question 12
Answer A is incorrect. HKAS 38 requires disclosure of the carrying amount of a class of
revalued intangible assets as though the class had been measured using the cost model.
(A similar disclosure is required of property, plant and equipment measured using the
cost model.)
Answer B is correct. An entity must disclose the effective date of the revaluation for each
class of intangible assets measuring using the revaluation model. However, the entity does
not have to make a statement the class has not been revalued, if this is the case, it may be
good practice to do so.
Answer C is incorrect. HKAS 38 requires disclosure of the amount of the revaluation
surplus that relates to intangible assets at the beginning and end of the period.
Answer D is incorrect. Disclosure is required of the amortisation charged on intangible
assets measured using the revaluation model. (Recall that under the revaluation model
intangible assets are measured at the revalued amount less any subsequent accumulated
amortisation and impairment.)
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EXAM PRACTICE
QUESTION 1
MHL Limited (MHL) controls a wholly-owned subsidiary SDL Limited (SDL) together the MHL
Group. You are the Financial Controller of the MHL Group. The MHL Group’s consolidated
financial statements for the financial year ended 31 December 20X8 are currently being
reviewed by the members of the MHL Group’s Audit Committee.
One of the directors, Ms. Tess Chow, has noticed that a poker machine licence held
by SDL has been recognised in the consolidated financial statements at its fair value on
31 December 20X8 although it is only recognised on a cost basis in the financial statements
of SDL. Tess would like for other MHL Group intangible assets to be recognised at their fair
values in the MHL Group consolidated financial statements because ‘Doing this will improve
our net asset position. Also, it is more representative of the true value of MHL Group;
therefore, this is information useful to users of our financial statements’.
She has asked for your opinion on the following items:
• MHL has a brand name, Magica, which has become well known since MHL
developed it 10 years ago. Valuation experts have valued the brand name at
HK$5 million. Tess would like to recognise this brand name as an intangible asset
and report it at HK$5 million in the consolidated financial statements of MHL.
• MHL holds a non-renewal 20-year patent for Product X that it acquired five years
ago for HK$2 million. Tess estimates the patent to have a fair value at year end
of HK$10 million and would like to report this patent at HK$10 million in MHL’s
consolidated financial statements.
Required:
Prepare a memo to Tess analysing the proposed accounting treatment for the Magica brand
name and the patent in the MHL Group consolidated financial statements for the year ended
31 December 20X8.
QUESTION 2
(Adapted from Module A December 2015 Paper)
Positive Clips Limited (PCL) is developing a software system for making a new
product for sale:
• Between 1 January and 30 June 20X1, the project incurred costs of HK$2 million to
evaluate the possible system specifications.
• Between 1 July and 31 December 20X1, the project incurred technicians’ salaries of
HK$4 million to build the software system to the specifications identified.
PCL completed its technical feasibility study of the system in June 20X1, showing there
are no technical barriers to completing the system. It expects the system will be ready for
use by the end of 20X2 and will become obsolete after eight years.
PCL plans to patent the software system with the appropriate regulatory authority: The
patent will have a legal life of five years. The patent can be renewed once, for a further five
year period. The cost of renewing the patent for the further period is minimal.
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PCL plans to programme the software system in its existing production line in making
the new product, which it will sell it to the market. It expects that the future economic
benefits the software system and associated machinery will generate will outweigh all the
necessary expenditures incurred in the project.
Assume that all funding and other resources have been secured.
Required:
(a) With reference to the phases of developing the software system, advise the accounting
implication for each of the preceding incurred costs.
(b) Advise PCL about the commencement of the amortisation period of the software
system and analyse the length of the amortisation period.
QUESTION 3
(Adapted from Module A December 2017 Paper)
Hydro Power Limited (HPL) manufactures and assembles irrigation systems. As at 31
December 20X6, HPL had a research and development (R&D) project aimed at developing a
hydro-powered irrigation pump by using kinetic energy to pump water to higher elevations
without the need for active mechanical parts to provide a more sustainable irrigation system
for sale to farmers in mainland China. HPL commenced the project on 1 March 20X6.
The following activities were carried out by HPL during the year.
• To obtain more information on current technology of kinetic energy and alternate
materials for the pump to be more durable, HPL sent specific R&D members to
attend local and regional exhibitions. Salaries and travelling costs incurred by these
research and development (R&D) members amounted to HK$650,000.
• After concluding that it is technically feasible to develop the product, HPL also
recruited a well-known technical expert on kinetic energy to design and test the
prototype before full-scale production of the products because the board was
convinced the products would have good markets and be profitable based on its
research and business plans. Salary costs paid to the technical expert for his service
amounted to HK$900,000.
• To promote the products, HPL developed and launched a new website solely for
advertising the products. Total costs incurred for the website were HK$170,000,
of which HK$100,000 was spent on developing the infrastructure for the site and
HK$70,000 was spent on graphic design and content development.
• HPL also purchased an operating system for a machine to test the strength of the
irrigation pump that amounted to HK$41,000. The machine could not operate
without this operating system.
• In addition, HPL spent HK$200,000 to register a patent for the software for a period
of two years. The patent is renewable for another two years at minimum cost.
The irrigation pump is expected to give HPL a competitive edge for three years following
commercial production.
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Required:
Advise HPL as to the accounting implications (initial recognition and subsequent
measurement) of the relevant costs of the R&D project incurred during the year ended 31
December 20X6.
ANSWERS TO EXAM PRACTICE
QUESTION 1
MEMORANDUM
To: Ms. Tess Chow, Director of MHL
From: Melody Li, Accounting Manager
Date: dd/mm/20X8
Subject: Brand name and patent measurement in the consolidated financial statements
of MHL Group
I refer to your queries regarding the brand name and patent measurement in the
consolidated financial statements of the MHL Group.
Brand name
The Magica brand name is an internally generated intangible asset as it was
developed by MHL.
HKAS 38 specifically prohibits the recognition of internally generated brand names
because it is impossible to determine the cost of the asset reliably. This is because
expenditure on internally generated brands cannot be distinguished from the cost of
developing the business as a whole. (As a result, an internally generated brand name cannot
meet the criteria set out in HKAS 38 for recognition as an intangible asset.) Therefore,
because the Magica brand name cannot be recognised in the MHL Group consolidated
statement of financial position, it follows that the brand name cannot be measured at its
fair value.
Patent
A patent cannot be revalued under HKAS 38 as it is a unique intangible asset, and therefore,
no active market exists for the asset. HKAS 38 does not permit revaluation to fair value
for assets for which an active market does not exist. Consequently, the patent must be
measured at its cost less accumulated amortisation less accumulated impairment and
cannot be revalued to HK$10 million.
Because the patent is expected to expire in 20 years, it should be amortised over 20
years to a nil residual value. The annual amortisation charge is HK$2 million/20 years, i.e.
HK$100,000 per annum. Hence, the patent must be recognised at HK$1.5 million in MHL’s
consolidated financial statements for the year ended 31 December 20X8.
QUESTION 2
(a) HKAS 38 distinguishes between two phases in the generation of an intangible asset
internally: the research and development phases. Costs incurred during the research
phase are expensed in accordance with HKAS 38.
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The costs associated with evaluating possible system specifications are research
costs because they are incurred with the intent of gaining new knowledge rather
than creating a practical application from which future economic benefits will flow.
Therefore, these costs do not meet the criteria for recognition of an internally
generated asset. These costs are expensed in profit or loss.
The technicians’ salaries are incurred during the development phase because
these costs were incurred as part of the application of the research findings to a design
for the production of the new software systems before starting to use the system.
Pursuant to HKAS 38, an intangible asset arising from development (or from the
development phase of an internal project) should be recognised if and only if an entity
can demonstrate all of the following:
• The technical feasibility of completing the intangible asset so that it will be available
for use or sale;
• Its intention to complete the intangible asset and use or sell it;
• Its ability to use or sell the intangible asset;
• How the intangible asset will generate probable future economic benefits. Among
other things, the entity can demonstrate the existence of a market for the output of
the intangible asset or the intangible asset itself or, if it is to be used internally, the
usefulness of the intangible asset;
• The availability of adequate technical, financial and other resources to complete the
development and to use or sell the intangible asset; and
• Its ability to reliably measure the expenditure attributable to the intangible asset
during the development phase.
Once all the above criteria are fulfilled from June 20X1, PCL can demonstrate the
following:
• The technical feasibility of completing the project has been proved;
• It intends to complete building the system;
• It has decided it will use the system to enable it to produce the new product, which
is expected to generate probable future economic benefits for PCL through sale;
• There are no financial or other resource barriers to it completing the project; and
• As indicated by its ability to identify the technicians’ salaries, the entity can measure
the expenditure attributable to the intangible asset during the development phase.
Therefore, development costs from June 20X1 can be capitalised as part of the cost
of the intangible asset. In accordance with HKAS 38, only those costs that are directly
attributable to preparing the intangible asset for use are capitalised as part of the cost
of the intangible asset.
Here, the technicians’ salaries, a development cost, can be capitalised as the salaries
were incurred after the criteria for recognition of the asset were met and were directly
incurred to build the software system.
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(b) The amortisation period of the software system begins from the date the system
is in the condition and location necessary for it to be capable of operating in the
manner intended by management, that is, the asset is available for use. This is by the
end of 20X2.
The intangible asset is amortised over its useful life (the length of the amortisation
period). The estimated useful life of the intangible asset is the period over which the asset
is expected to be available for use by the entity. This is not an indefinite period as there
is a foreseeable limit to the period over which the asset is expected to generate net cash
flows for the entity because the asset will become obsolete after eight years. The useful
life of the intangible asset is estimated to be eight years as this is the period PCL expects
the software system to be available for use; it will become obsolete after that time.
When estimating the useful life, PCL has to regard the period of any legal limits
on the use of the asset. The software system is protected by patent for up to 10 years
because the renewal period is included in the estimate of useful life when there is
evidence to support renewal by the entity without significant cost. Here, as PCL expects
to use the asset for longer than five years and as the patent is renewable without any
significant cost, evidence suggests the patent will be renewed for five more years,
that is, a total 10 years. However, as the patent does not limit PCL’s use of the asset, it is
irrelevant to the consideration of the software system’s useful life.
PCL considers the patent for recognition as a separate (externally acquired)
intangible asset because it represents PCL’s right to deny others access to future
economic benefits of the software system. On acquisition of the patent, PCL recognises
it at cost. The patent is amortised to nil over a useful life of 10 years. The patent cannot
be revalued to fair value as, being specific, there is no active market for it.
QUESTION 3
HKAS 38 Intangible Assets requires all internal expenditure that may result in an intangible
asset be distinguished between two phases: the research and the development phases.
Costs incurred during the research phase are expensed because it cannot be demonstrated
that future economic benefit will flow to the company.
The salary and travelling costs of HK$650,000 incurred by the selected R&D team
members are costs incurred to search for new technology and possible suppliers of
alternate materials. As such, they are research costs and should be expensed as incurred.
Directly attributable costs incurred in the development phase are recognised as
intangible assets if and only if an entity can demonstrate that the six conditions for
recognition are met: (1) the technical feasibility of completing the intangible asset so it will
be available for use or sale; (2) its intention to complete the intangible asset and use or sell
it; (3) its ability to use or sell the intangible asset; (4) 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; (5) the availability
of adequate technical, financial and other resources to complete the development and
to use or sell the intangible asset; and (6) the ability to measure reliably the expenditure
attributable to the intangible asset during its development.
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IPR&D
The hiring of the expert to design and test the prototype before full-scale production
demonstrates that HPL had intention to complete the technically-feasible intangible asset
so that it would be available for use. The salary costs paid to the expert are considered to
be incurred in the development phase because the expert was employed after and as soon
as the board members were convinced that the products would have good markets and be
profitable, that is, there is evidence of HPL’s ability to use the intangible asset and for it to
generate probable future economic benefits. The salary costs are a directly attributable cost
of the intangible asset because they would not have been otherwise incurred. As such, the
salary costs of HK$900,000 paid to the expert should be recognised as part of the cost of the
IPR&D intangible asset.
The directly attributable costs forming the cost of the IPR&D intangible asset are
amortised from the time it is in the location and condition necessary for it to be capable
of operating in the manner intended by management. This is expected to be at the time of
commercial production and may begin before the patent is obtained. The useful life of the
intangible asset is the period over which it is available for use, which is the three years from
commercial production for which HPL will have a competitive edge over its competitors.
Website development costs
An intangible asset should be recognised for website development costs where the general
recognition requirements of HKAS 38 and the six conditions for recognition as development
costs are met, including demonstrating that the website will generate probable future
economic benefits for the entity. HPL is unable to demonstrate how the website will
generate probable future economic benefits because it was developed solely or primarily
for promoting and advertising its own products and services. As such, the total costs of
HK$170,000 spent on the developing and launching of the website should be expensed
as incurred.
Operating system
The operating system of HK$41,000 should be regarded as an integral part of the machine
as the machine could not operate without this operating system. As such, the cost should be
recognised as part of the cost of the machine under HKAS 16 Property, Plant and Equipment
and depreciated over the useful life of the machine. A portion of the cost may qualify for
capitalisation as part of the cost of each unit of the irrigation system produced.
Patent
The amount paid for the patent registration of HK$200,000 should be recognised as an
intangible asset at cost. As the asset arises from a legal right, in accordance with HKAS 38,
the intangible asset is amortised over the shorter of the period of the legal rights and period
over which the entity expects to use the asset.
As the patent can be renewed with a minimal cost or without a significant cost, its
useful life as determined by its legal rights is four years. However, as the intangible asset
is expected to bring a competitive edge for HPL for only the three years from commercial
production, the patent registration fee recognised as an intangible asset should be
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I ntan gible Assets
amortised over that shorter period. Amortisation of the asset begins on commencement of
the patented period.
Until the recognised intangible assets are in the location and condition necessary for it to
be capable of operating in the manner intended by management, the intangible asset must
be tested for impairment annually and whenever there is an indication of impairment. Once
amortisation begins, the intangible asset should be reviewed at the end of each reporting
period for any indication that impairment exists. Where there is an indication of impairment,
the recoverable amount of the intangible asset is determined and the asset written down as
necessary. (Refer to Chapter 14 for further details.)
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12
Financial Assets, Financial
Liabilities and Equity
Instruments
CHAPTER TOPIC LIST
12.1 Overview 12.4 Measurement of Financial
12.1.1 Relevant Accounting Liabilities
Standards Overview and 12.4.1 Initial Measurement of
Linkage Financial Liabilities
12.1.2 Scope and Terminology 12.4.2 Subsequent Measurement of
12.1.3 Classification Financial Liabilities
12.4.3 Reclassifications
12.2 Recognition
12.4.4 Gains and Losses
12.2.1 Initial Recognition
12.2.2 Regular Way Purchase or 12.5 Financial Guarantee Contracts
Sale of a Financial Asset 12.5.1 Initial Recognition
12.5.2 Subsequent Measurement
12.3 Measurement of Financial
Assets 12.6 Derecognition
12.3.1 Initial Measurement of 12.6.1 Derecognition of a Financial
Financial Assets Asset
12.3.2 Subsequent Measurement of 12.6.2 Derecognition of a
Financial Assets Financial Liability
12.3.3 Reclassifications 12.6.3 Partial Derecognition
12.3.4 Gains and Losses 12.7 Treasury Shares
12.3.5 Impairment and Credit
Losses
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12.8 Compound Financial 12.10 Disclosure
Instruments Measurement 12.10.1 S tatement of Financial
12.8.1 Convertible Instruments Position Disclosures
that Are Not Compound 12.10.2 Statement of Profit or Loss
Instruments and Other Comprehensive
12.8.2 Split Accounting: Initially and Income Disclosures
Subsequently 12.10.3 Other Disclosures
12.9 Derivatives 12.10.4 Nature and Extent of Risks
12.9.1 Derivative Financial Arising from Financial
Instruments Instruments
12.9.2 Simple Embedded Derivatives 12.10.5 Transfer of Financial
12.9.3 Application of Own-use Assets
Exemption 12.11 Current Developments
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L E A R N I N G O UTC O MES
PRINCIPAL LO2: APPLY APPROPRIATE ACCOUNTING PRINCIPLES AND CONCEPTS TO ACCOUNT
FOR BUSINESS TRANSACTIONS
LO2.05: D
escribe and account for business transactions in accordance with Hong Kong Financial
Reporting Standards as they relate to: Financial Assets, Financial Liabilities and Equity
Instruments
2.05.01 A
pply the criteria for the recognition and de-recognition of a financial asset or
financial liability
2.05.02 A
pply the principles for the classification of financial assets, financial liabilities and equity
instruments, and their measurement (including compound instruments)
2.05.03 A
ccount for the financial assets, financial liabilities and equity instruments
2.05.04 A
pply the appropriate treatment for the impairment of financial assets
2.05.05 A
ccount for derivative financial instruments and simple embedded derivatives, including the
application of own-use exemption
2.05.06 Account for treasury shares
2.05.07 P
repare disclosure in respect of financial assets, financial liabilities and equity instruments
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OPENING CASE
BELVUE ELECTRONICS
B elvue Electronics (Belvue) is a Hong Kong company that manufactures processor
components used primarily to automate the flight operations of aircraft. Belvue imports
commodities, such as gold from Australia and platinum from South Africa, for use in circuitry.
It also imports carbon fibre components from mainland China to house the end product.
Belvue exports the processor components it produces to France and the United States where
aircraft manufacturers acquire them for use in their aircraft.
Recently, Belvue received an order for its product that was larger than any before, due
to the construction of a new aircraft product line. Belvue does not have the working capital
available to fill the order. Therefore, it is considering options for raising debt. Jason, Belvue’s
Chief Financial Officer, knows that increasing the entity’s leverage needs to be carefully
managed. Furthermore, Belvue might need to obtain funding from outside of Hong Kong
or provide special terms in its debt instruments to ensure the cost of funding is kept to a
minimum.
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OVERVIEW
Financial instruments are a core feature of almost every business. The simplest financial
instrument comes with delayed payment terms. Whenever an entity agrees to exchange a good
or service for a promise of future compensation, a financial instrument is created in the form
of a payable or receivable. This type of transaction is often an entity’s greatest exposure to
financial instruments. The majority of financial instruments in Belvue’s financial statements will
be these types of receivables and payables, that is, trade debtors and trade creditors.
In recent decades, however, more complicated financial instruments have become
prevalent, even in otherwise simple businesses. An entity may borrow funds in other
jurisdictions, which introduce foreign currency risk to their cash flows, or a business loan could
have multiple interest rates included in its pricing, such as a mix of fixed and variable interest
payments. These complex features are introduced through tailored financial instruments
intended to solve a particular business need.
In some circumstances, an entity will be unable to negotiate the specific credit or other
terms it desires to provide or receive in a transaction. But by entering into related transactions,
the entity may be able to position itself where it desires or at least closer than is possible
when negotiating with the immediate other party. For example, a supplier may be prepared
to receive only a particular currency in payment. The purchaser may not wish to be exposed
to changes in the exchange rate for that currency between order and payment dates. The way
this might be resolved is for the purchaser to swap its exposure to the supplier’s currency to
say, its own currency, through a contract with a financial intermediary. Entering into that swap
is a separate transaction, but it effects the net exposure of the purchaser and has accounting
consequences as shall be outlined later.
The swap referred to above is one form of derivative used to manage foreign exchange
risk. However, derivatives may be used to manage almost any risk; including commodity prices,
interest rates and even the risks arising from weather events. As a result, a derivative contract
is often available for any exposure an entity wishes to manage.
Financial instruments may be used to manage an entity’s risks, but they may also be used
for speculative purposes, where a position is taken with a view to benefit from changes in the
pricing of that position. For example, an entity may agree to purchase a quantity of foreign
currency at one price, hoping that it can sell that quantity, or the rights to that quantity,
when exchange rates move in a favourable direction. That entity may have no need at all for
that currency.
Given the widespread use of financial instruments for numerous purposes, the accounting
requirements for them are voluminous. Do not underestimate the effort required to
understand these requirements.
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1 2 . 1 OVERVIEW
This chapter addresses the accounting for financial instruments, which is set out in three
accounting standards devoted to the topic. This section introduces these standards, their
scope and their interaction with one another. Finally, this section introduces a primary principle
for the classifying of financial instruments as financial assets, financial liabilities, or equity
instruments.
Throughout this chapter, the following graphic (Exhibit 12.1) will be used to illustrate where
the content being covered fits into the broader topic of accounting for financial instruments.
The graphic represents the typical life cycle of a financial instrument.
Subsequent
Contract Derecognition
measurement
Financial instrument? Initial measurement
Classification
• Financial asset
• Financial liability Recognition
• Equity instrument
• Compound instrument
EXHIBIT 12.1 Life cycle of a financial instrument
The first part of this section covers the requirements for a contract to be considered a
financial instrument through the examination of the scope of each of the accounting standards.
12.1.1 Relevant Accounting Standards Overview and Linkage
Three accounting standards prescribe the requirements for financial instruments: HKFRS 9
Financial Instruments, HKFRS 7 Financial Instruments: Disclosures and HKAS 32 Financial
Instruments: Presentation (collectively referred to as the ‘financial instruments standards’ in
this chapter).
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12.1.1.1 HKFRS 9 Financial Instruments
HKFRS HKFRS 9 Financial Instruments is primarily concerned with recognition and measurement of
9.IN1 financial assets, financial liabilities and some contracts to buy or sell non-financial items.
HKFRS 9 does not address how to distinguish financial assets from financial liabilities. For this,
it depends on HKAS 32 Financial Instruments: Presentation (see Section 12.1.1.3). Therefore, to
properly account for a financial instrument, understanding HKFRS 9 in conjunction with
HKAS 32 is required.
HKRS 9 also covers derecognition of financial instruments, hedge accounting, measurement
of credit losses and impairment of financial assets for other reasons.
12.1.1.2 HKFRS 7 Financial Instruments: Disclosures
HKFRS HKFRS 7 Financial Instruments: Disclosures prescribes the disclosure requirements for the vast
7.IN4 majority of risks arising from financial instruments. HKFRS 7 is one of only a few accounting
standards devoted solely to disclosure requirements and for good reason. Due to the
complexity in accounting for financial instruments, the disclosure requirements must find the
balance between understandability for the user and faithful presentation of the complexity of
the entity’s exposures. Accordingly, HKFRS 7 is highly dependent on the entity’s classification
decision made in accordance with HKAS 32 (see Section 12.1.1.3) and its application of the
recognition and measurement requirements of HKFRS 9.
12.1.1.3 HKAS 32 Financial Instruments: Presentation
HKAS 32 Financial Instruments: Presentation prescribes the requirements for classifying a
HKAS financial instrument as a financial asset, financial liability or equity instrument from the
32.2 perspective of the entity as an issuer. Apart from defining financial instruments, it directly
affects how the financial instruments are presented in the financial statements. Furthermore,
HKAS 32 prescribes when financial assets and financial liabilities must be offset (netted)
HKAS against one another in those statements, which is not ordinarily permitted under HKAS 1
1.32 Presentation of Financial Statements. HKAS 32 is fundamental to the application of HKFRS 9
and HKFRS 7.
12.1.2 Scope and Terminology
Central to the scopes of the financial instruments standards is the definition of a financial
HKAS instrument. A financial instrument is any contract that gives rise to a financial asset of one
32.11 entity and a financial liability or equity instrument of another entity.
All the financial instruments standards begin by describing their scope as applicable by all
entities to all financial instruments. However, each standard provides some exceptions to its
scope to avoid confusion with the requirements of other standards.
The scope exclusions generally relate to transactions or events otherwise within the scopes
of another HKFRS, as summarised in Exhibit 12.2:
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Standard Example See Module 11
chapter specified
HKFRS 2 Share-based Payment An obligation to compensate another party, Chapter 24
based on the value of the entity’s own
shares (except for an arrangement to buy or
sell a non-financial item that is not for the
entity’s own use)
HKFRS 3 Business Combinations A forward contract between an acquirer Chapter 29
and a selling shareholder that will result in a
business combination
HKFRS 10 Consolidated Financial Interests in subsidiaries, associates or joint Chapters 30, 32
Statements, HKAS 27 Separate ventures accounted for at cost or applying and 33
Financial Statements and HKAS 28 the equity method
Investments in Associates and Joint
Ventures
HKFRS 15 Revenue from Contracts Contract assets and contract liabilities that Chapter 5
with Customers represent the entity’s entitlement to revenue
or obligation to deliver goods or services
HKFRS 16 Leases A lease liability representing future lease Chapter 9
payments
HKFRS 17 Insurance Contracts Liabilities for remaining insurance coverage Chapter 26
(claims not incurred) and liabilities for
incurred claims
HKAS 19 Employee Benefits Short-term and long-term employee benefits Chapter 23
such as annual leave and personal leave
HKAS 37 Provisions, Contingent Reimbursement rights in respect of Chapter 18
Liabilities and Contingent Assets provisions recognised
EXHIBIT 12.2 Scope exclusions
The above standards may specify whether any of the requirements in the financial
instruments standards must be applied in specified cases. For example, HKFRS 16 requires an
HKFRS 9.2.1 entity to apply the derecognition and impairment requirements of HKFRS 9 to lease receivables
HKFRS recognised by a lessor, and HKFRS 15 requires an entity to apply the impairment requirements
15.107 of HKFRS 9 to contract assets.
HKFRS 9 also applies to certain loan commitments. A loan commitment is a contract in
which the entity agrees to provide credit to another party at an agreed future date or at the
potential lender’s option. A common example is a credit card. If the holder of the card has not
used it, the available balance of the card is a loan commitment. These loan commitments are
within the scope of HKFRS 9 if:
• The entity designates the loan commitment as measured at fair value through profit or
loss (see Section 12.3.2 for a discussion of the ability to make this designation, which
applies equally to financial liabilities);
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• The loan commitment may be settled net in cash or another financial asset between
the parties. For example, if a loan commitment may be settled between two entities by
extinguishing all asset and liability positions that exist between the entities; and
• Any loan commitment to provide a loan at below-market interest rates.
A financial asset is any asset that is:
• Cash;
• An equity instrument of another entity;
• A contractual right:
°° To receive cash or another financial asset from another entity; or
°° To exchange financial assets or financial liabilities with another entity under
conditions potentially favourable to the entity; or
HKAS • A contract that will or may be settled in the entity’s own equity instruments, subject to
32.11 conditions specified in HKAS 32 (covered in Section 12.1.3).
A financial liability is any liability that is:
• A contractual obligation:
°° To deliver cash or another financial asset to another entity; or
°° To exchange financial assets or financial liabilities with another entity under
conditions potentially unfavourable to the entity; or
HKAS • A contract that will or may be settled in the entity’s own equity instruments, subject to
32.11 conditions specified in HKAS 32 (covered in Section 12.1.3).
HKAS An equity instrument is any contract that evidences a residual interest in the assets of an
32.11 entity after deducting all of its liabilities.
HKFRS 9 provides an exemption from the definition of a financial instrument for any
contract entered into and continues to be held for the purpose of the receipt or delivery of a
HKFRS non-financial item in accordance with the entity’s expected purchase, sale, or usage
9.2.4 requirements. For example, Belvue might enter into a contract to purchase raw materials for
use in production in 18 months. This contract is ordinarily exempt from the requirements of
HKFRS 9. Despite the exemption, an entity may elect to designate the contract as measured at
HKFRS fair value through profit or loss (see Section 12.3.2 for a discussion of this designation, which
9.2.5 applies equally to financial liabilities).
12.1.3 Classification
In this section, we consider how to classify the types of financial instruments that may be
encountered (Exhibit 12.3).
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Subsequent
Contract Derecognition
measurement
Financial instrument? Initial measurement
Classification
• Financial asset
• Financial liability Recognition
• Equity instrument
• Compound instrument
EXHIBIT 12.3 Life cycle of a financial instrument
Often, classifying a financial instrument either as a financial asset, a financial liability or an
equity instrument is straightforward. After all, being promised to receive cash (a financial asset)
or promising to pay another entity cash (a financial liability) are common examples.
However, a contractual obligation to exchange cash is not the only source of financial
assets or financial liabilities. As indicated in the definitions provided in Section 12.1.2, a promise
to exchange financial assets or financial liabilities with another entity can also give rise to:
• A financial asset where that exchange is potentially favourable to the entity; or
• A financial liability where that exchange is potentially unfavourable to the entity.
For more complicated financial instruments, think of the HKAS 32 classification
requirements as a waterfall. Anything that does not meet the definition of a financial asset or
a financial liability will be classified as an equity instrument (unless the ‘puttables exemption’
applies: see Section 12.1.3.1). This view may be useful when attempting to classify instruments
that will or may be settled in the entity’s own equity instruments.
An instrument that will or may be settled other than by delivering a fixed amount of cash or
HKAS another financial instrument in exchange for a fixed amount of the entity’s own equity
32.11 instruments will not be an equity instrument. Conversely, an instrument that will be settled
with the exchange of a fixed amount of cash or another financial asset in exchange for a fixed
number of the entity’s own equity instruments will be classified as an equity instrument; this is
called the ‘fixed-for-fixed’ test (see Section 12.8.1.1).
For example, a contract that requires the holder to acquire a fixed number (e.g. 100) shares
of the entity in exchange for fixed consideration of say HK$100 will be classified as an equity
instrument in the entity’s financial statements. The holder of that instrument faces the same
price risk as existing holders of shares. If prices go up, he or she will enjoy the benefit of the
gain in value over what they pay. If the prices go down, he or she will lose.
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On the other hand, if the contract required the entity to issue a variable number of the
entity’s shares to ensure the holder receives HK$100 worth of shares, that contract would be
classified as giving rise to a financial liability. The holder is not at risk as is an equity holder.
It will always get $100 worth of shares by the issuance of more or fewer shares. There is no
residual risk to the holder.
As previously indicated, we return to the topic of puttable instruments later (see
Section 12.1.3.1). In narrow circumstances, a written put option will not be treated as giving rise
to a financial liability when written options are otherwise classified as liabilities. The puttable
instruments in question, in narrow circumstances, enable owners to withdraw from their equity
holdings in the entity and for the instrument to be treated as giving rise to a transaction with
owners and not the settlement of a liability.
Transactions can be constructed in a way that involves a number of parts. Some parts
may meet the definition of equity, but others may meet the definition of a liability. These are
known as compound financial instruments. (See Section 12.1.3.2 and Section 12.8.) So, when
reading the flowchart below, suspend your thinking about compound instruments and puttable
instruments until you reach the identified discussion.
Exhibit 12.4 provides an overview of the classification decisions required when considering
a basic financial instrument in its entirety.
Does the contract contain
an obligation for the issuer
to deliver cash or another
financial asset?
Yes No
Does the instrument fall
within the scope of the Equity
puttables exemption?
No Yes
Does the instrument Are the puttables
contain any equity exemption criteria
components? satisfied?
Yes Compound Yes
Equity
instrument
No No
Liability Liability
EXHIBIT 12.4 Classifying financial instruments
12.1.3.1 The ‘Puttables Exemption’
Some shares of entities permit the holder to ‘put’ the share back to the issuing entity at, or
prior to, liquidation. This ‘put’ obligation requires the entity to redeem the share in exchange
for cash or another financial instrument. Ordinarily, the requirement to deliver cash or another
financial instrument would be classified as a financial liability because it meets that definition
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as specified in HKAS 32. However, if the instrument meets the following conditions, it is, by
exception, to be classified as an equity instrument:
• The instrument entitles the holder to a pro-rata share of the entity’s net assets on
liquidation;
• The instrument is in a class of instruments subordinate to all other claims;
• All instruments in that class of instruments have identical features;
• The instrument has no other characteristic that would meet the definition of a financial
liability; and
• 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, loss or change in recognised net
assets for this purpose is as measured in accordance with relevant HKFRS.
In addition to the criteria above, the entity must have no other instrument with terms
HKAS
32.16A– equivalent to the last bullet point above, and that has the effect of substantially restricting or
16B, 16D fixing the residual return to the holders of the puttable financial instruments.
HKAS Furthermore, any instrument that may only be put back to the issuer on liquidation may
32.16Cx also be classified as an equity instrument if it meets the conditions above.
A common example of a puttable instrument that might meet the above criteria is the
holding of a dairy farmer in a dairy cooperative. The puttable instrument enables the farmer
to withdraw from the cooperative, often when retiring from the industry. In a way, the puttable
instrument enables the entity to reduce its equity base.
Key Learning Point
The puttable exemption allows some financial instruments to be classified as equity in
circumstances where their nature is more akin to an equity instrument, but the legal form
would appear to be a financial liability. This exemption is, therefore, targeted primarily at
entities that do not issue traditional equity instruments (such as shares) but where the
characteristics of the instruments they do issue are consistent with shares nonetheless.
12.1.3.2 Compound Financial Instruments
As previously indicated, some financial instruments have more than one component. This means
that they combine elements of financial assets, financial liabilities and equity instruments.
For example, a contract may require an entity to make fixed payments to the holder but
permit the holder to exchange that stream of cash flows for a fixed amount of the entity’s equity
instruments. The most common example of this type of instrument is a convertible bond. For
a time, interest is payable on the bond and then, in certain circumstances, the bond may be
converted into shares. The instrument is like any other term borrowing except that it has another
component that may, at the option of the holder, lead to the issuance of equity instruments.
Accounting for compound financial instruments (including convertible bonds, convertible
either at the option of the holder (as previously mentioned) or the entity) is considered in
Section 12.8.
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Apply and Analyse 1
Hi-Tech Research Limited (HTRL) issues preference shares with a par value of HK$100
each. Holders of these shares are permitted to put them back to HTRL at fair value at any
time prior to liquidation. On liquidation, the preference shares entitle their holders to a
pro-rata share of HTRL’s net assets and rank equally to ordinary shareholders (i.e. they
are subordinate to the entity’s outstanding debts). Prior to liquidation, HTRL must pay
a dividend equal to 5% of the par value of the preference shares if any dividend is paid
on ordinary shares. If no dividend is paid on ordinary shares, the dividend that would
otherwise have been paid to preference shareholders accumulates to future periods.
Identify how the entity should classify these preference shares.
Analysis
Referring to Exhibit 12.4, the first step in classifying the preference shares is to determine
whether HTRL has a contractual obligation to pay cash or deliver another financial asset
to the shareholders. In this case, HTRL is required to pay dividends to the shareholders,
and those dividends accumulate similar to other payables when the cash is not transferred
in a particular period. Therefore, HTRL has a contractual obligation to pay cash to the
shareholders, and the preference shares are not automatically classified as equity
instruments.
HTRL next considers whether the instruments fall within the scope of the puttables
exemption in HKAS 32. Because the instruments are puttable back to the entity, they are
not the most subordinate to other obligations because the dividend accumulates and is
payable ahead of ordinary shareholders, and they also impose cash flows (the dividends)
that meet the definition of a financial liability. Accordingly, the preference shares are not
within the scope of the puttables exemption.
Finally, the shareholders cannot exchange their right to cash flows for ordinary shares,
and therefore, they do not contain an equity component. Consequently, the preference
shares are classified as financial liabilities in their entirety.
Knowledge Check Questions
Question 1
Identify whether any of the following arrangements are within scope of HKFRS 9.
A An agreement to pay a third party an amount of cash linked to the share price of
the entity
B An obligation to pay a monthly payment to a lessor for the occupancy of a building
C A contract to purchase equity instruments of another entity if the contract enables the
other party to require the entity to do so
D A probable obligation to pay cash but the entity is not currently contractually required to
deliver the cash
Question 2
Describe the primary focus of HKAS 32, HKFRS 7 and HKFRS 9.
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1 2 . 2 RECOGNITION
To this point, we have been concerned with identifying and classifying financial assets, financial
liabilities and equity instruments that stem from financial instruments. The next step (see
Exhibit 12.5) is to recognise those elements in the financial statements.
Subsequent
Contract Derecognition
measurement
Financial instrument? Initial measurement
Classification
• Financial asset
• Financial liability Recognition
• Equity instrument
• Compound instrument
EXHIBIT 12.5 Life cycle of a financial instrument
Recognition involves timing (when to recognise) and leads to the fundamental issue of
measurement (what basis of measurement to apply, e.g. or cost or fair value). The latter issue is
dealt with in Sections 12.3 and 12.4.
12.2.1 Initial Recognition
HKFRS An entity must recognise a financial instrument when it becomes party to a contract that
9.3.1.1 establishes rights or obligations on the entity. This is usually straightforward and often
coincides with legal execution of the contract. But as with other areas of accounting, one must
ensure this is when the definitions previously discussed are first met.
12.2.2 Regular Way Purchase or Sale of a Financial Asset
Most financial instruments establish legally enforceable rights and obligations on the entity
from the day they are entered into. However, in some markets or jurisdictions, a financial
instrument may be traded on one day, but the legal rights and obligations of the instrument
only settle with the entity on a future date.
For example, an entity might acquire equity instruments of another entity on a Monday at
HK$90, but the market may only transfer those equity instruments to the entity on Wednesday.
Monday is the day the entity committed to the purchase (trade date), and Wednesday is the day
the right to those instruments is settled by their delivery (settlement date).
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An entity using trade date accounting would record the right to the shares, and from that
date, any adjustments it would normally process if those shares were held. So, if the shares
would be marked to fair value, the trade date entitlement would also be marked to fair value
until and after the shares are received.
An entity using settlement date accounting would bring the shares to account when
received at HK$90 and then apply its normal accounting. If, as above, that was fair value, there
would be an immediate adjustment for any change in value between Monday and Wednesday.
The choice between the trade date and settlement date is one for entities to make on
practical grounds. The difference in accounting is largely a timing issue. For some entities, the
difference in timing will not be an issue. For others, it may become complicated If the trade
date is not the point of initial recognition.
HKFRS Whichever accounting approach an entity chooses for a transaction, it must apply that
9.B3.1.3 approach consistently to all such transactions.
If the instrument could be net settled in the period between the two dates, it would not be
HKFRS a regular way instrument but instead would give rise to a derivative that must be recognised
9.B3.1.4 immediately.
1 2 . 3 MEASUREMENT OF FINANCIAL ASSETS
Once an entity has classified a financial instrument as a financial asset and recognised it in the
financial statements, the entity must measure it initially and subsequently.
As shown in Exhibit 12.6, this section discusses measurement. This section explores the
measurement of financial assets (financial liabilities are considered in Section 12.4) and the
associated impairment requirements because of the interrelationship of measuring the actual
financial asset with the requirements to recognise a provision for impairment in some cases.
Subsequent
Contract Derecognition
measurement
Financial instrument? Initial measurement
Classification
• Financial asset
• Financial liability Recognition
• Equity instrument
• Compound instrument
EXHIBIT 12.6 Life cycle of a financial instrument
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HKFRS 9 prescribes measurement requirements that depend on the characteristics of
the cash flows flowing from the financial asset and the entity’s business model for managing
the class of financial assets to which the asset in question belongs. This approach is intended
to provide users of the financial statements with useful information relevant to the entity’s
operations.
HKFRS 9 provides limited exceptions to the measurement requirements, such as when the
entity applies hedge accounting (see Chapter 13) and when certain circumstances exist in which
overriding the measurement requirements will provide more relevant information to users.
This section considers these requirements in detail and notes where they are overridden.
12.3.1 Initial Measurement of Financial Assets
Most financial assets are measured at fair value on initial recognition. The initial measurement
HKFRS includes transaction costs directly attributable to the financial asset for those measured at
9.5.1.1 amortised cost or fair value through other comprehensive income (FVTOCI). Transaction costs
are excluded from the initial measurement of financial assets measured at fair value through
profit or loss; instead, those transaction costs are immediately recognised in profit or loss on
initial recognition.
A notable exception to this is for trade receivables that do not contain a significant
HKFRS financing component, which are initially measured at their transaction price as determined
9.5.1.3 under HKFRS 15 Revenue from Contracts with Customers (see Chapter 5).
Transaction costs are the incremental costs that are directly attributable to the acquisition,
issue or disposal of a financial asset (or financial liability). An incremental cost is one that
would not have been incurred if the entity had not acquired, issued or disposed of the financial
instrument.
12.3.2 Subsequent Measurement of Financial Assets
Though financial assets are all initially measured at fair value, their subsequent measurement
HKFRS
9.4.1.1– depends principally on entity’s business model for managing the class of assets, what the asset
4.1.4 in question belongs to and the cash flow characteristics of the asset. Three classifications of
subsequent measurement are possible in HKFRS 9, depending on the entity’s business model
for holding that asset and the characteristics of the cash flows arising from the asset.
Exhibit 12.7 highlights the three subsequent measurement classifications, and Exhibit 12.8
illustrates how the entity’s business model determines which classification must be used.
Fair value through profit
or loss (FVTPL)
Subsequent
measurement
Fair value through
Amortised cost other comprehensive
income (FVTOCI)
EXHIBIT 12.7 Subsequent measurement
classifications for financial assets
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The entity’s business model can be any one of the following three:
1. Hold to collect: Under this model, the entity is primarily to collect the contractual
receipts arising on the asset. Irregular sales, including when a sale is expected, do not
necessarily preclude an asset from being classified in this business model. For example,
sales to manage credit risk or credit concentration risk are generally acceptable.
Essentially, the sales must be incidental to the overall business model.
2. Hold to collect and sell: Similar to the hold to collect model, the entity achieves its
objectives through collecting contractual cash flows. However, assets under this
business model may be sold prior to maturity to achieve the entity’s objectives.
Such sales will occur more frequently than in a hold to collect model and will not be
incidental to the model but instead be integral to it.
3. Not held to collect: In this business model, the entity does not manage the asset in a
business model that considers contractual cash flows at all, and the primary
HKFRS
9.B4.1.1– consideration is realisation through sale. Here the collection of contractual cash flows is
B4.1.6 incidental to the overall business model.
The business model must be considered in conjunction with the cash flow characteristics of
the financial asset in question. Cash flows need to be solely payments of principal and interest
(SPPI) on the principal amount outstanding to potentially be classified as anything other than
subsequently measured at fair value through profit or loss (FVTPL).
HKFRS 9 states that SPPI cash flows are consistent with a ‘basic lending arrangement’. In a
basic lending arrangement, time value of money and credit risk are the most significant
elements of the interest rate charged. However, costs to the entity, a reasonable profit margin
HKFRS and adjustments for liquidity risk may also be present in the interest rate charged and still be
9.B4.1.7A consistent with a basic lending arrangement.
Understanding the concept of a basic lending arrangement is critical to applying the SPPI
test, and HKFRS 9 provides extensive guidance to assist in applying the concept. Already
discussed are the key features of a basic lending arrangement but also important are
features not considered consistent with a basic lending arrangement. This includes applying
leverage to the contractual cash flows of an asset. For example, the cash flows of a financial
asset might be modified by a multiple of an index or rate, for example, twice the Hong Kong
Interbank Offered Rate (HIBOR). Leverage modifies cash flows in a way that doesn’t
HKFRS compensate the counterparty for the time value of money, profit, or other costs. As such,
9.B4.1.9 leverage is not considered a component of interest. Another contractual term that requires
careful consideration is one that modifies the timing of the contractual cashflows arising
from a financial asset. If the timing of contractual cash flows are modified without adjusting
for the time value of money (e.g. a contract prepayable at any point to maturity for a fixed
amount), it contractual term will probably not be considered consistent with a basic lending
arrangement and, by extension, consistent with the notion of interest. On the other hand, if
the contractual term adjusted the timing of cash flows and their amount in consideration of
the concept of interest (e.g. a prepayment option that depended on the duration the
principal amount was outstanding plus an element of reasonable compensation), that term
HKFRS will more likely be consistent with the notion of interest and, therefore, a basic lending
B4.1.10 arrangement.
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Apply and Analyse 2
Hong Kong Important Company (HKIC) issues a variable rate instrument with a stated
maturity. The interest paid on the instrument is calculated based on a benchmark market
rate of interest plus an adjustment for the credit risk of HKIC. However, HKIC is permitted
to select a Hong Kong Interbank Offered Rate (HIBOR) that applies to a particular period as
long as the period of the selected benchmark rate matches the period of the instrument in
question. For example, HKIC can choose to apply a 3-month HIBOR rate to a three-month
interest accrual period or the one-month HIBOR rate to a one-month interest accrual
period. Determine whether this instrument meets the SPPI test.
Analysis
In this case, the only components of interest are the HIBOR rate and a margin for the credit
risk HKIC. On this initial assessment, it would appear the only components of interest
are to compensate the lender for the time value of money and a credit risk adjustment,
which are consistent with a basic lending arrangement. However, the option for HKIC to
select which HIBOR rate to apply to a period is not, at face value, consistent with a basic
lending arrangement. Upon further analysis, HKIC is restricted to selecting a HIBOR rate
that matches the period over which interest needs to be calculated. In essence, this can be
analogised to a rolling credit facility where, at the end of each period, the borrower informs
the lender that it wishes to extend the period of its facility for a specified amount of time,
and then the appropriate HIBOR rate is matched. Viewed this way, the arrangement does
appear to be a basic lending arrangement because the various HIBOR rates are calculated
to represent the time value of money for specified periods.
If, on the other hand, HKIC was able to select any HIBOR rate to apply to any period of
time, such as a one-month HIBOR tenor to apply to a six-month period, this would modify
the lenders compensation for the time value of money and require more detailed analysis.
Based on the facts of the instrument in question, the SPPI test is satisfied.
Exhibit 12.8 illustrates the relationship between the entity’s business model for managing
a class of assets and the cash flow characteristics of the asset being classified. For example,
if an asset is managed in a hold to collect business model and meets the SPPI test, it will be
measured at amortised cost. If the cash flow characteristics of the asset do not meet the SPPI
test the asset must be measured at fair value through profit or loss regardless of the business
model applicable to that asset.
As an exception to the preceding classification requirements, an entity may make an
irrevocable election on initial recognition to subsequently measure a financial asset at fair
HKFRS value through profit or loss if doing so significantly reduces or eliminates a measurement or
9.4.1.5 recognition inconsistency (sometimes referred to as an accounting mismatch). For this
requirement to apply, the entity must be managing a financial asset, a financial liability, or a
group of financial assets and financial liabilities together. Furthermore, such a designation
HKFRS must result in the presentation of more relevant information to users of the financial
9.B4.1.27 statements.
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SPPI Not SPPI
Amortised
Hold to collect FVTPL
cost
Business Hold to collect
FVTOCI FVTPL
model and sell
Hold to sell FVTPL FVTPL
EXHIBIT 12.8 Effect of a business model and cash flows on subsequent
measurement
For example, an entity might manage a financial asset and a financial liability together
because they share the same risk (such as interest rate risk), but either one of the instruments
might not qualify for hedge accounting (see Chapter 13). If the financial liability were
subsequently measured at fair value through profit or loss (see Section 12.4.2) but the financial
asset were not measured on the same basis, the entity may elect to designate the financial
asset as also measured at fair value through profit or loss to present more relevant information
to users of the financial statements.
Also, where the asset is an equity instrument of another entity, that asset may be
HKFRS subsequently measured at FVTOCI if it is neither held for trading nor contingent consideration
9.5.7.5 in a business combination.
Illustrative Example 1
Belvue Electronics (Belvue) holds a portfolio of US Treasury Bonds for a short time
when it has excess working capital but does not necessarily intend to hold the bonds
until their maturity. Therefore, the portfolio consists of bonds that might mature within
Belvue’s investment time horizon, or Belvue intends to sell the bonds to deploy the funds
elsewhere. Accordingly, Belvue holds these instruments in a business model with the
objective to collect contractual cash flows and sell the instruments. The instruments pay
fixed interest coupons that compensate the holder for the time value of money and an
insignificant amount of US Government credit risk. Accordingly, the instruments meet
the SPPI test. Based on these facts (and following Exhibit 12.8), Belvue classifies the
instrument as a financial asset measured at FVTOCI.
12.3.2.1 Amortised Cost and the Effective Interest Method
Financial assets subsequently measured at amortised cost are measured using the effective
interest method. This means that interest revenue and the carrying amount of the financial
asset are dependent on the effective interest rate. This contrasts with instruments measured
at FVTOCI where only the interest revenue on the instrument is calculated using the effective
interest method; its carrying amount is purely based on fair value (see Section 2.3.2.2).
Assets measured at fair value through profit or loss are not affected by the effective interest
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method; even interest earned on those assets is captured purely in their fair value movements
presented in profit or loss (see Section 2.3.2.3).
The effective interest method (EIM) relies on the effective interest rate. The effective
interest rate is defined as that which exactly discounts estimated future cash payments or
HKFRS receipts through the expected life of the financial asset or financial liability to the gross carrying
9 App. A amount of the financial asset or to the amortised cost of a financial liability. Where transaction
costs that are integral and incremental to obtaining the financial asset are incurred, those costs
are adjusted against the initial measurement of the asset, along with any premiums or
discounts. This will affect the effective interest rate of the instrument. By adjusting the effective
interest rate of the instrument, HKFRS 9 requires that transaction costs, premiums, or discounts
are amortised over the life of the instrument as opposed to being recognised in profit or loss
on initial recognition.
Apply and Analyse 3
Asia Goods Manufacturing Company (AGMC) purchases three-year Hong Kong SAR
Government Bonds at a face value of HK$1 million but only pays HK$950,000. The bonds
pay a fixed annual coupon of 2.46%, and the entity pays HK$20,000 in directly attributable
incremental transaction costs in the form of brokerage fees to acquire the bonds.
Assume the bonds will be subsequently measured at amortised cost. Calculate the
initial carrying amount of the bonds and the effective interest rate that will apply.
Analysis
The first step that AGMC must complete is to determine the initial carrying amount
of the bonds, which is their face value, adjusted for any premiums, discounts and any
transaction costs.
Calculating the initial carrying amount of the bond
HK$
Face value 1,000,000
Less:
Discount (50,000)
Brokerage costs 20,000
Carrying amount 970,000
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Apply and Analyse 3 (continued)
Next, AGMC must determine the cash flows arising on the financial asset over its
expected life, which is three years. These cash flows are illustrated in the table below.
Cash flows arising from the bond
Year 1 2 3 Total
HK$ HK$ HK$ HK$
Interest 24,600 24,600 24,600 73,800
Principal – – 1,000,000 1,000,000
Total 24,600 24,600 1,024,600 1,073,800
Over the life of the instrument, AGMC expects to receive HK$1,073,800 on an
undiscounted basis. To determine the effective interest rate of the instrument, AGMC must
solve for the discount rate to apply to each cash flow that will discount those cash flows to
the initial carrying amount of the instrument. This operation is illustrated with the present
value formula shown below.
Calculating EIR
24 , 600 24 , 600 1, 024 , 600
970, 000 [ ] [ ] [ ]
1 RATE (1 RATE ) 2
(1 RATE))3
Unfortunately, the rate must be solved with trial and error, or a financial calculator.
If applying trial and error, one can start with the coupon rate stated for the instrument
(2.46%). The carrying amount of the financial asset is less than its face value, and
therefore, the discount rate must be higher than the stated coupon rate. Discounting a
face value from HK$1,000,000 to HK$970,000 will require a large adjustment to the stated
coupon rate. As a first test, AGMC chooses a rate of 4.80%, which yields a present value
of HK$936,036. This is close but has lowered the present value too much. AGMC needs
to lower the discount rate to raise the present value to the target of HK$970,000. AGMC
next tries a rate of 3.00%, yielding a present value of HK$984,725. AGMC has lowered the
rate too far and needs to increase the rate to lower the present value. This process of
trial and error continues until the entity obtains a rate that correctly solves the formula.
Using software (e.g. the Microsoft Excel IRR function), AGMC would determine the exact
rate as 3.53%.
Illustrative Example 2
Belvue’s financial controller purchases HK$5 million-worth of US Treasury Bonds with a
stated 3% interest paid annually and a maturity of three years. Brokerage costs incurred
were HK$100,000.
The table below shows the cash flows associated with the bond. In the table below,
a negative number represents a cash outflow, and positive numbers are cash inflows.
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Illustrative Example 2 (continued)
Interest is shown at the contractual amount receivable, which is 3% of the face value of the
bonds. This example assumes the fair value of the bonds remains constant, meaning the
calculations reflect amortised cost measurement. This example also ignores the effect of
foreign currency translation.
Cash flows on US Treasury Bonds:
Initial measurement Year 1 interest Year 2 interest Year 3 interest
plus principal
HK$ HK$ HK$ HK$
(5,100,000) 150,000 150,000 5,150,000
Using the Microsoft Excel IRR function returns an effective interest rate of 2.3024%.
A financial calculator can also be used to determine this rate. However, an effective
interest rate can only be determined manually through the use of trial and error.
The following table summarises the amortisation schedule for the US Treasury Bonds:
Year Opening Effective Contractual Difference Closing
amortised Interest interest between EIM amortised
cost Method (EIM) interest and cost
interest contractual
revenue interest
HK$ HK$ HK$ HK$ HK$
A B = A x EIR C D=C–B E=A–D
0 – – – – 5,100,000
1 5,100,000 117,422 150,000 32,578 5,067,422
2 5,067,422 116,672 150,000 33,328 5,034,094
3 5,034,094 115,906 150,000 34,094 5,000,000
Total 350,000 450,000
The table above illustrates the interest revenue Belvue records in each year it holds the
bond in comparison to the contractual interest it receives in cash from the counterparty. In
total, the interest revenue recognised under the effective interest method is HK$100,000
less than the contractual interest received. This difference represents the amortisation of
the brokerage cost incurred when Belvue acquired the US Treasury Bonds.
In Year 3, the US Treasury Bonds mature, and Belvue receives HK$5 million.
Throughout the life of these bonds, Belvue records the following journal entries.
Debit Credit
HK$ HK$
Investment in US Treasury Bonds 5,100,000
Cash 5,100,000
(Initial recognition of US Treasury Bonds plus brokerage transaction cost)
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Illustrative Example 2 (continued)
Debit Credit
HK$ HK$
Cash 150,000
Investment in US Treasury Bonds 32,578
Interest revenue 117,422
(Year 1 interest revenue and amortisation of transaction cost)
Debit Credit
HK$ HK$
Cash 150,000
Investment in US Treasury Bonds 33,328
Interest revenue 116,672
(Year 2 interest revenue and amortisation of transaction cost)
Debit Credit
HK$ HK$
Cash 150,000
Investment in US Treasury Bonds 34,094
Interest revenue 115,906
(Year 3 interest revenue and amortisation of transaction cost)
Debit Credit
HK$ HK$
Cash 5,000,000
Investment in US Treasury Bonds 5,000,000
(Year 3 maturity of bonds)
12.3.2.2 Fair Value through Other Comprehensive Income
When a financial asset is measured at fair value through other comprehensive income (FVTOCI),
an entity must calculate interest revenue using the effective interest rate but recognise the
financial asset at fair value. In practice, this means an entity must recognise interest revenue on
the basis of an amortised cost measurement but make an adjustment to that value to reflect
fair value movements.
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Illustrative Example 3
Assume the same facts as in the Illustrative Example 2 except that the US Treasury
bonds are classified as at FVTOCI because Belvue Electronics (Belvue) holds them in a
liquidity portfolio where the bonds may be sold prior to maturity to provide cash for use
elsewhere in the business. This means the bonds are held in a business model to collect
contractual cash flows but also to potentially sell them. The fair value of the US Treasury
bonds is shown below at the end of the indicated year.
Fair value of US Treasury Bonds:
Year 1 Year 2 Year 3
HK$ HK$ HK$
4,950,000 5,020,000 5,000,000
The table below repeats the interest revenue and cash receipts information from the
previous example but includes the fair value adjustment necessary to report the closing
balance of the bonds at the fair values quoted above. The table below presents values
according to their effect on the carrying amount of the financial asset. When a financial
asset is measured at FVTOCI, interest revenue is still calculated as if the asset where
measured at amortised cost using the effective interest method irrespective of the fair
value of that instrument in the relevant reporting period.
Amortisation schedule of US Treasury Bonds:
Year Opening EIM Cash Balance Fair value Closing
balance interest interest before adjustment balance
revenue fair
value
change
HK$ HK$ HK$ HK$ HK$ HK$
1 5,100,000 117,422 (150,000) 5,067,422 (117,422) 4,950,000
2 4,950,000 116,672 (150,000) 4,916,672 103,328 5,020,000
3 5,020,000 115,906 (150,000) 4,985,906 14,094 5,000,000
Belvue would record the following journal entries to record the above information.
Debit Credit
HK$ HK$
Investment in US Treasury Bonds 5,100,000
Cash 5,100,000
(Initial recognition of US Treasury Bonds plus brokerage transaction cost)
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Illustrative Example 3 (continued)
Debit Credit
HK$ HK$
Cash 150,000
Investment in US Treasury Bonds 32,578
Interest revenue 117,422
(Year 1 interest revenue and amortisation of transaction cost)
Debit Credit
HK$ HK$
Fair value movement reserve (OCI) 117,422
Investment in US Treasury Bonds 117,422
(Year 1 fair value adjustment)
Debit Credit
HK$ HK$
Cash 150,000
Investment in US Treasury Bonds 33,328
Interest revenue 116,672
(Year 2 Interest revenue and amortisation of transaction cost)
Debit Credit
HK$ HK$
Investment in US Treasury Bonds 103,328
Fair value movement reserve (OCI) 103,328
(Year 2 fair value adjustment)
Debit Credit
HK$ HK$
Cash 150,000
Investment in US Treasury Bonds 34,094
Interest revenue 115,906
(Year 3 interest revenue and amortisation of transaction cost)
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Illustrative Example 3 (continued)
Debit Credit
HK$ HK$
Investment in US Treasury Bonds 14,094
Other comprehensive income 14,094
(Year 3 fair value adjustment)
Debit Credit
HK$ HK$
Cash 5,000,000
Investment in US Treasury Bonds 5,000,000
(Year 3 maturity of bonds)
Refer to Section 12.3.4 for a discussion on the transfer of fair value movements
previously recognised in other comprehensive income to profit or loss on derecognition of
a financial instrument.
12.3.2.3 Fair Value through Profit or Loss
Accounting for financial instruments at fair value through profit or loss is simple in comparison
to the preceding measurement approaches. The key difference is that the effective interest rate
is not used to calculate interest revenue, and transaction costs are expensed to profit or loss
on initial recognition. All subsequent movements in the fair value of the financial asset are also
recognised immediately in profit or loss.
Exhibit 12.9 summarises the effect on the statement of financial position and profit or loss
arising from the three subsequent measurement models previously discussed.
Measurement Amortised cost Fair value through Fair value
Financial other comprehensive through profit
statement effect income or loss
Carrying amount Initial measurement Initial measurement Initial measurement
(statement of financial adjusted for adjusted for any adjusted for
position) repayments of subsequent changes in any subsequent
principal and fair value changes in fair
accrual of interest value
Interest (profit or loss) Calculated using the Calculated using the None
effective interest effective interest method
method
Fair value gains/losses None All fair value movements All fair value
(profit or loss) except interest recognised movements
in accordance with the including interest
effective interest method
EXHIBIT 12.9 Summary of measurement effects
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12.3.3 Reclassifications
HKFRS Financial assets may only be reclassified to another measurement model when the entity’s
9.4.4.1 business model for that asset changes.
HKFRS Changes in an entity’s business model for managing financial instruments are expected to
9.B4.4.1 be infrequent. HKFRS 9 places a high hurdle in meeting this test to prevent entities from
frequently changing the measurement of financial instruments, which would lead to confusion
among financial statement users. Changes to an entity’s business model for managing a
financial asset are determined by the entity’s senior management as a result of external or
internal changes and must be significant to the entity’s operations and demonstrable to
external parties. Accordingly, a change in an entity’s business model will occur only when an
HKFRS entity begins or ceases to perform an activity that is significant to its operations, for example,
9.B4.4.1 when the entity has acquired, disposed of or terminated a business line.
The following are not changes in an entity’s business model for managing a financial asset:
• A change in intention related to particular financial assets (even in circumstances of
significant changes in market conditions);
• The temporary disappearance of a particular market for financial assets; and
HKFRS
9.B4.4.3 • A transfer of financial assets between parts of the entity with different business models.
Exhibit 12.10 provides a summary of when an entity meets the requirements to reclassify a
HKFRS financial asset. All changes described in the following are applied prospectively only; the entity
9.5.6.1 does not restate any previously recorded movements. The table also summarises the effect of
the reclassification on the measurement of the impairment allowance for that asset (see
Section 12.3.5 for further discussion).
To Amortised cost Fair value through OCI Fair value through
From P&L
Amortised n/a Effective interest rate Fair value measured on
cost remains unchanged. Loss reclassification date. The
HKFRS allowance (see sum of the associated loss
9.5.6.4, Section 12.3.5) transferred allowance and any other
HKFRS
9.B5.6.1
to OCI. Fair value measured difference between the
HKFRS on reclassification date and amortised cost and fair
9.5.6.2 recorded in OCI. value of the instrument is
recognised in P&L.
Fair value Effective interest rate n/a The asset continues to be
through remains unchanged. Fair measured at fair value.
OCI value on reclassification date Any accumulate gains
becomes new gross carrying or losses recognised in
amount. Loss allowance OCI are transferred to
recognised as an adjustment P&L as a reclassification
to gross carrying amount on adjustment (including the
reclassification date. Any loss allowance).
HKFRS other accumulated
9.5.6.5, movements in OCI are
HKFRS
9.B5.6.1
recognised as an adjustment
HKFRS to the gross carrying amount
9.5.6.7 of the financial asset.
EXHIBIT 12.10 Summary of reclassification requirements
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To Amortised cost Fair value through OCI Fair value through
From P&L
Fair value The fair value of the asset on The fair value of the asset n/a
through the reclassification date on the reclassification
P&L becomes the new gross date becomes the new
carrying amount. An effective gross carrying amount.
interest rate is determined An effective interest rate
on the reclassification date is determined on the
and a loss allowance is reclassification date and a
determined as if the loss allowance is determined
HKFRS
9.5.6.3,
reclassification date was the as if the reclassification date
HKFRS initial recognition date was the initial recognition
9.B5.6.2 (through P&L). date (through OCI).
EXHIBIT 12.10 (Continued)
Illustrative Example 4
A bank operates a division that has the business model of trading residential mortgages
for profit. As a consequence, the mortgages are measured at fair value through profit or
loss because the bank is not holding the assets to collect their contractual cash flows. In
the current year, the bank decides to cease operating this trading division and, instead,
to hold the mortgages to collect their cash flows.
This change qualifies as a change in the entity’s business model for managing the
assets and satisfies the reclassification criteria.
Under the new business model, the bank assesses whether the mortgages meet the
solely payments of principal and interest (SPPI) test. Applying this test, the bank concludes
that the only elements of the interest rate charged to borrowers are consideration for the
time value of money, the credit risk of the borrower and a profit margin. All these elements
are consistent with a basic lending arrangement. Consequently, the change in the business
model is treated as a reclassification from the fair value through profit or loss category to
the amortised cost category.
On the reclassification date, one of the mortgages had a fair value of HK$610,000, fixed
interest payments of 4% per annum on a principal amount outstanding of HK$600,000
and a remaining life of three years to maturity. On the reclassification date, the bank uses
the fair value of the asset as the initial measurement for the purposes of determining the
effective interest rate on that date. Accordingly, the effective interest rate of the financial
asset is 3.47%. Assume the loss allowance on this asset is HK$50,000 (see Section 12.3.5 for
more detailed requirements).
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Illustrative Example 4 (continued)
On the reclassification date, the bank records the following journal entry.
Debit Credit
HK$ HK$
Impairment loss (P&L) 50,000
Loss allowance 50,000
(Recognise initial loss allowance on the reclassified financial asset)
No other journal entries are recorded on reclassification date. However, future interest
revenue will be calculated using the effective interest rate determined on reclassification
date (see Section 12.3.2).
12.3.4 Gains and Losses
Gains and losses on financial assets arise from multiple sources, such as market movements
and factors affecting parties to the contract. Whether and how these gains and losses are
recognised depends on which measurement category the financial asset belongs to and
whether the financial asset is part of a hedging relationship (see Chapter 13).
Dividends are recognised in profit or loss only when an entity’s right to the dividend is
established; the economic benefits of the dividend will probably flow to the entity and that
dividend can be measured reliably.
Exhibit 12.11 summarises the requirements of HKFRS 9 relating to the recognition of gains
and losses.
Measurement Recognition of gains or losses
classification
Financial assets Recognised in profit or loss when the financial asset is derecognised,
HKFRS subsequently measured reclassified (see Section 12.3.3), through the effective interest method or as
9.5.7.2 at amortised cost part of an impairment gain or loss.
Financial assets Generally, through other comprehensive income except for impairment
HKFRS subsequently measured gains and losses or foreign exchange gains and losses, which are recognised
9.5.7.10 at fair value through in profit or loss.
other comprehensive Equity instruments designated as measured at fair value through other
HKFRS
income comprehensive income (FVTOCI) have all gains and losses (including foreign
9.B5.7.3 exchange gains and losses) recognised in other comprehensive income.
On derecognition of a financial asset measured at FVTOCI, other than equity
instruments included in this classification, the fair value movements on the
asset recognised in other comprehensive income is transferred to profit or
loss (sometimes referred to as recycling).
HKFRS
9.5.7.1 Financial assets In profit or loss.
subsequently measured
at fair value through
profit or loss
EXHIBIT 12.11 Summary of requirements to recognise gains and losses
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12.3.5 Impairment and Credit Losses
HKFRS 9 requires an entity to recognise an expected credit loss provision (sometimes referred
to as an allowance for credit impairment or an allowance for bad and doubtful debts under
the superseded HKAS 39 Financial Instruments: Recognition and Measurement) on all financial
assets not measured at fair value through profit or loss. The intention is to present to users
of the financial statements with an estimation of the credit risk associated with an entity’s
financial assets. This approach requires that entities consider all reasonable and supportable
information available to the entity without undue cost or effort when estimating the expected
credit loss associated with a financial asset.
Expected credit loss measurement is not meant to convey the loss an entity anticipates
making on a financial asset. Instead, it is a statistical measure based on a range of outcomes
and probability-weighted loss amounts.
HKFRS 9 defines the term credit loss as the difference between all contractual cash flows
that are due to an entity in accordance with the contract and all the cash flows that the entity
expects to receive (i.e. all cash shortfalls), discounted at the original effective interest rate (or
credit-adjusted effective interest rate for purchased or originated credit-impaired financial
assets). Expected credit losses extends the definition of a credit loss and is defined as the
weighted average of all credit losses with the respective risks of a default occurring as the
weights. The credit-adjusted effective interest rate and purchased or originated credit-impaired
financial assets are considered in Section 2.3.5.3.
Illustrative Example 5
Worldwide Financing Limited (WFL) provides loans to small and medium size enterprises.
WFL has a loan owing from Cosmos Limited (Cosmos). The loan is measured at
amortised cost and had an original effective interest rate of 6.2188%. Cosmos has been
experiencing financial difficulty and WFL expects that not all contractual cash flows under
the loan will be received. WFL has prepared the below summary of contractual cash flows
and cash flows expected to be received from Cosmos:
Contractual Expected Cash shortfall
cashflow cashflow
HK$ HK$ HK$
Year 1 50,000 40,000 (10,000)
Year 2 50,000 40,000 (10,000)
Year 3 550,000 500,000 (50,000)
Total 650,000 580,000 (70,000)
The starting point for WFL in determining the credit loss related to Cosmos is to
calculate the difference between all contractual cash flows (HK$650,000) and all cash
flows that it expects to receive (HK$580,000). The cash shortfalls of HK$70,000 are then
discounted at the loan’s original effective interest rate of 6.2188% over the remaining term
of the loan to arrive at a credit loss of HK$60,000.
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12.3.5.1 General Approach
The general approach to expected credit loss impairment follows a three-stage approach.
The stage a financial asset belongs to is dependent on its credit risk at the reporting date
compared to its credit risk at initial recognition. Credit risk is the risk that one party to a
financial instrument will cause a financial loss for the other party by failing to discharge an
obligation. For example, a highly leveraged entity will have a higher credit risk than an entity
not leveraged at all.
Three-Stage Approach to Credit Losses
Exhibit 12.12 illustrates the three-stage model and the key features of each.
• 12-month expected credit losses - being the portion of lifetime expected credit losses that
result from default events on a financial instrument that are possible within the 12 months
following the reporting date
Stage 1 • Interest revenue calculated on gross carrying amount – being the amortised cost of the
financial asset before adjusting for any loss allowance
• Lifetime expected credit losses - being the expected credit losses that result from all possible
default events over the expected life of a financial instrument
Stage 2 • Interest revenue calculated on gross carrying amount
• Lifetime expected credit losses
• Interest revenue calculated on net carrying amount – being the gross carrying amount after
Stage 3 adjusting for any loss allowance
EXHIBIT 12.12 Summary of three-stage impairment model
As a financial asset migrates through the three stages above, the loss provision held against
the asset is adjusted. Finally, when one or more events with a detrimental impact on the
cash flows the financial asset occurs (such as a breach of contract or the borrower becomes
bankrupt), the asset becomes credit impaired and it enters Stage 3 of the impairment model.
In Stage 3, the amount of interest revenue recognised on the asset is measured with reference
to the net carrying amount of the asset, in other words, the gross carrying amount less the loss
allowance in respect of that asset.
Except for purchased or originated credit impaired financial assets, a financial asset that
HKFRS
has not experienced a significant increase in credit risk since initial recognition will belong to
9.5.5.5 Stage 1 of the general impairment model. Generally, this means that when an asset is first
recognised (unless it is a purchased or originated credit impaired asset), that financial asset will
begin in Stage 1.
HKFRS
If, since initial recognition, the financial asset experiences a significant increase in credit risk
9.5.5.3 (see Section 12.3.5.1.2), the financial asset will migrate to Stage 2. Finally, if the financial asset
HKFRS
becomes credit impaired, the entity will recognise interest revenue based on the net carrying
9.5.4.1(b) amount of the financial asset, which is Stage 3 of the impairment model.
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Significantly Increased Credit Risk
The key determinant of which stage of the impairment model an asset belongs to is whether a
significant increase in credit risk has occurred since initial recognition. Generally, a significant
HKFRS increase in credit risk will occur before a financial asset becomes credit-impaired or an actual
9.B5.5.7 default occurs. This approach aims to ensure that an entity recognises potential losses on
financial assets before they become credit-impaired. Consequently, users of the financial
statements will be able to assess whether an entity’s exposure to financial assets puts it at risk
of significant losses in the future.
When determining whether a significant increase in credit risk has occurred, an entity shall
HKFRS consider all reasonable and supportable information that is available without undue cost or
9.B5.5.15 effort to the entity.
Some factors that may indicate a significant increase in credit risk include:
• Changes in market indicators for the financial instrument (or similar instruments), such
as credit spreads, prices for credit default swaps for the borrower, the length of time, or
the extent to which the fair value of the instrument is less than its amortised cost;
• An actual or expected downgrading of the internal credit rating of the borrower; and
HKFRS • An actual or expected significant change in the operating results of the borrower, such
9.B5.5.17 as reduced revenue or margins, increased operating costs, or increased leverage.
HKFRS Furthermore, there is a rebuttable presumption that, when a financial asset becomes more
9.5.5.11 than 30 days past due, a significant increase in credit risk has occurred.
Modified Financial Assets
If an entity modifies a financial asset, for example, through renegotiating the term of the asset,
HKFRS and the financial asset is not derecognised, an entity must consider whether the modification
9.5.5.12 results in a significant increase in credit risk. The reason for this is that a renegotiation of a
financial asset is sometimes undertaken when the borrower is facing difficulty servicing the
asset on its original terms. In this case, an entity might renegotiate the contract to ensure it
may still recover the amount advanced to the borrower but over a longer period of time.
To determine whether a significant increase in credit risk occurred, an entity compares the
risk of default occurring at the reporting date using the modified terms of the instrument with
the risk of default occurring on initial recognition of the unmodified terms.
Key Learning Point
In essence, the entity still follows the same approach described in Section 12.3.5.1, but
HKFRS 9 clarifies that the comparison for modified financial assets is still against the risk of
default since initial recognition and not since modification.
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Apply and Analyse 4
Belvue provides the option to customers to enter into a financing arrangement whereby
the customer can make large, one-off, purchases under a three-year loan facility requiring
fixed principal and interest payments on a monthly basis. Belvue only provides this facility
to its largest customers who have a long history with the company and have excellent
credit ratings. One such customer decides to finance the acquisition of a HK$1 million
order of avionics equipment. On initial recognition, Belvue determines that the loan is not
a purchased or originated credit-impaired asset (see Section 2.3.5.3) and estimates the
probability-weighted credit losses over the lifetime of the loan to be HK$50,000. Of that
amount, HK$10,000 relates to expected credit loss events that could occur in the next
12 months.
In Year 2, the customer informs Belvue it is facing a significant delay in collecting its
own receivables as an explanation for why some repayments have been late. Ordinarily,
the customer would be able to maintain its payment schedule through sales of unrelated
products, but it is also facing a reduction in those sales. At this point, Belvue re-estimates
the probability-weighted credit losses over the lifetime of the loan to be HK$70,000. Later
that year, the customer informs Belvue it will be unable to pay the loan back to Belvue in
full and on time. Instead, the customer is only able to pay HK$400,000 of the HK$600,000
outstanding.
Determine in which stage of the expected credit loss model the loan is categorised
at initial recognition, at the first communication from the customer and at the final
communication. Also calculate the expected credit loss provision at each point and the
corresponding effect on profit or loss.
Analysis
The loan provided to the customer is a financial asset measured at amortised cost and
is, therefore, subject to the expected credit loss model in HKFRS 9. On initial recognition,
HKFRS 9 requires an entity to recognise an expected credit loss provision equal to the
expected loss attributable to default events that could occur in the next 12 months.
This requirement always applies except where the asset is a purchased or originated
credit-impaired asset, which is not the scenario in this case. Therefore, Belvue categorises
the loan into Stage 1 of the expected credit loss impairment model. Though the lifetime
expected credit losses are estimated at HK$50,000 on initial recognition, Belvue only
recognises a provision for HK$10,000 because the lower amount is what is attributable to
loss events that could occur in the next 12 months. This provision is recognised as a loss in
profit or loss.
Belvue notices that payments from the customer have been becoming later than due
in recent months; when the customer first informs Belvue it is having cash flow difficulties,
Belvue determines this represents a significant increase in credit risk. Factors in this
decision include that the customer indicated it is experiencing a downturn in sales and,
therefore, is making late repayments. If this is the case for a major supplier like Belvue,
the customer is probably experiencing significant cash flow issues. Furthermore, the
customer indicated it is facing a downturn in sales in other products, which indicates the
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Apply and Analyse 4 (continued)
customer is likely to see poor operating performance for the year. Accordingly, Belvue
transfers the loan to Stage 2 of the expected credit loss model. At this stage, Belvue still
anticipates collecting the entire loan amount outstanding and, therefore, does not consider
that a credit impairment event has occurred. In Stage 2, Belvue increases the provision to
lifetime expected credit losses at the re-estimated amount of HK$70,000. This provision is
increased by recognising a HK$60,000 loss in profit or loss.
The final communication from the customer indicates that Belvue will only recover
HK$400,000 of the outstanding HK$600,000. This notification signals a significant
detrimental impact to the cash flows Belvue was expecting to receive. Accordingly, the loan
is transferred into Stage 3 of the expected credit loss model. At this stage, the loss on the
loan is expected to be HK$200,000, being the difference between the balance outstanding
and the amount the customer is able to repay. Accordingly, the expected credit loss
provision needs to be increased from HK$70,000 to HK$200,000, requiring recognition of a
loss of HK$130,000 in profit or loss.
12.3.5.2 Simplified Approach: Trade and Lease Receivables
HKFRS HKFRS 9 requires an entity to recognise credit losses equal to lifetime expected credit losses
9.5.5.15 (Stage 2) for trade and lease receivables. This means an entity is not required to determine and
track the risk of default and any increases in credit risk of these receivables from initial
recognition.
The exception is for trade receivables that contain a significant financing component as
HKFRS defined in HKFRS 15. However, an entity may still elect, as an accounting policy choice, to
9.5.5.15(a)(ii) measure the expected credit losses of such receivables at their lifetime expected credit losses.
12.3.5.3 Purchased Credit-impaired Approach
Purchased or originated credit-impaired assets are already credit-impaired at initial recognition.
This means the borrower has experienced events that have a significant detrimental impact
on the cash flows associated with the financial asset. This is common for entities that acquire
‘distressed’ loans from banks at a significant discount to their original value. In these cases, the
entities hope the borrower can still repay their debt, yielding a profit to the acquirer equal to
the sum of the discount received on their acquisition and interest received over the term of
the lending.
Purchased or originated credit-impaired financial assets are initially recognised at fair value,
including transaction costs if measured at amortised cost. However, the effective interest rate
of the financial asset must be adjusted for credit risk. This differs from the calculation of the
effective interest rate for financial assets that are not purchased or originated credit-impaired
(refer to Apply and Analyse 3 in Section 12.3.2.1). For purchased or originated credit-impaired
financial assets, the entity adjusts the effective interest rate for future expected credit losses on
HKFRS initial recognition. Such a rate aims to reflect the impaired nature of the financial asset on initial
9.5.4.1(a) recognition.
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Furthermore, unlike financial assets not purchased or originated credit-impaired financial
assets, an entity does not recognise a loss allowance on initial recognition because the fair
value of the asset will already be adjusted for the future expected losses.
Illustrative Example 6
Optimist Limited (Optimist) purchases a bond issued by Tuff Times Limited (Tuff Times),
an entity experiencing significant financial hardship. The bonds have a face value of
HK$1 million, pay annual coupons of 3.5% and have three years remaining to maturity.
However, given the distressed nature of Tuff Times, the transaction price is HK$750,000.
Optimist estimates lifetime expected credit losses of HK$300,000; in other words,
Optimist only expects to recover HK$700,000 of the HK$1 million face value of the bonds.
Accordingly, the cash flow estimates are as follows.
Initial Year 1 interest Year 2 interest Year 3 interest plus
measurement principal less ECL
HK$ HK$ HK$ HK$
(750,000) 35,000 35,000 735,000
The credit-adjusted effective interest rate is 2.4991%, which discounts the expected
receipt of HK$700,000 of the principal amount outstanding and the expected interest
receipts to the day 1 initial investment. Because the initial purchase price of the bond has
incorporated an estimate of future losses, Optimist does not recognise an expected credit
loss provision for this bond (unlike ordinary financial assets).
On initial recognition Optimist manages the asset to collect its contractual cash flows,
which are purely payments of principal and interest on the principal amount outstanding.
Accordingly, Optimist classifies the investment as subsequently measured at amortised
cost. Optimist then applies the credit-adjusted effective interest rate to the amortised cost
of the financial asset to recognise interest revenue.
If an entity revises its expectation of future cash flows on purchased or originated
credit-impaired financial assets, the entity will recognise the difference in future expected
cash flows as an impairment gain or loss when that revised estimate is made. The carrying
amount and effective interest rate of the credit-impaired asset are not changed.
12.3.5.4 Recognition of Credit Losses
As loans migrate through the three stages of the expected credit loss model, the estimated
amount of the provision will change. These changes are recognised in profit or loss. The
corresponding adjustment to the statement of financial position is reflected in:
HKFRS • A loss allowance for financial assets measured at amortised cost, a lease receivable, a
9.5.5.1 contract asset, a loan commitment or a financial guarantee contract; and
HKFRS • Equity for financial assets measured at fair value through other comprehensive income
9.5.5.2 (FVTOCI).
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The intention for recognising credit losses in different parts of the statement of financial
position is to ensure recognition will follow the subsequent measurement requirements for
the financial asset. For example, where an asset is measured at FVTOCI (and accumulated in a
separate component of equity), it makes sense to record credit losses in the same location to
avoid introducing artificial volatility in profit or loss.
Illustrative Example 7
As indicated in Apply and Analyse 4 in Section 12.3.5.1, Belvue Electronics (Belvue)
extends a three-year loan facility to one of its major customers which has been
transacting with Belvue for over a decade. The loan facility allows the customer to draw
a maximum of HK$2 million (less an origination fee of HK$55,000) for purchases from
Belvue within 30 days of being granted the credit. On 1 January 20X3, the customer
utilises the entire facility in a single transaction. At drawdown, the following facts are
relevant to the facility.
Principal HK$2,000,000
Term 3 years
Interest rate 6.5000%
Repayment type Principal and interest
Repayment frequency Semi-annual
Repayment amount HK$372,260
Origination fee HK$55,000
Effective interest rate 8.2032%
On the day that Belvue originates this loan for its customer, Belvue determines the
loan is not a purchased or originated credit-impaired asset because it has substantial
experience with the customer indicating no financial difficulty in the past. Furthermore,
Belvue has no indications the customer will be unable to repay the facility in accordance
with the contractually agreed terms. Therefore, Belvue estimates the lifetime expected
credit losses to equal HK$150,000. The portion of that amount that relates to possible
events of default occurring within the next 12 months is HK$50,000.
On 1 January 20X3, Belvue’s financial controller prepares the following amortisation
table on the assumption the customer does not experience any significant change in
its credit risk. As the amount outstanding reduces so does the expected credit losses
associated with the facility. Also, the initial gross carrying amount equals the principal
amount advanced of HK$2 million less the origination fee received of HK$55,000.
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Illustrative Example 7 (continued)
Period Opening Cash EIM Principal Gross ECL
balance received interest reduction and carrying
revenue fee amortisation amount
HK$ HK$ HK$ HK$ HK$ HK$
Jan 20X3 – – – – 1,945,000 (50,000)
Jul 20X3 1,945,000 (372,260) 79,776 (292,484) 1,652,516 (42,000)
Jan 20X4 1,652,516 (372,260) 67,780 (304,480) 1,348,036 (35,000)
Jul 20X4 1,348,036 (372,260) 55,291 (316,969) 1,031,067 (25,000)
Jan 20X5 1,031,067 (372,260) 42,290 (329,970) 701,097 (15,000)
Jul 20X5 701,097 (372,260) 28,756 (343,504) 357,593 (10,000)
Jan 20X6 357,593 (372,260) 14,667 (357,593) – –
On 1 January 20X3, Belvue records the following journal entries.
Debit Credit
HK$ HK$
Loan receivable from customer 1,945,000
Cash 1,945,000
(Recognise the initial carrying amount of the loan to the customer)
Debit Credit
HK$ HK$
Impairment gains/losses (P&L) 50,000
Loss allowance 50,000
(Recognise the initial value of the expected credit loss allowance)
On 1 July 20X3, the customer makes its scheduled repayment, thereby reducing the
amount outstanding. Belvue also assesses the customer’s credit risk has not changed.
Accordingly, the lifetime expected credit losses attributable to the financial asset changes only
due to the reduction in the amount outstanding. The following journal entries are recorded.
Debit Credit
HK$ HK$
Cash 372,260
Interest revenue 79,776
Loan receivable from customer 292,484
(Repayment from customer and interest revenue)
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Illustrative Example 7 (continued)
Debit Credit
HK$ HK$
Loss allowance 8,000
Impairment gains/losses 8,000
(Recognise reduction in expected credit losses arising from repayment)
The customer continues to make payments as scheduled. However, in August 20X4,
Belvue becomes aware the customer has lost a major contract owing to a significant
deterioration in economic conditions. The customer assures Belvue it will still be able to
repay the loan as scheduled. Belvue determines that though the credit risk associated
with the loan has increased, it is not yet significant enough to warrant migrating the loan
to Stage 2.
In December 20X4, Belvue observes that economic conditions have continued to
deteriorate, and the customer’s sales have declined. The customer still assures Belvue it
can repay the loan; however, Belvue determines the credit risk has significantly increased
since origination. Accordingly, on 1 January 20X5, when the customer makes a repayment
Belvue also migrates the loan to Stage 2, increasing the expected credit losses associated
with the loan to the lifetime estimate of HK$100,000.
Debit Credit
HK$ HK$
Cash 372,260
Interest revenue 42,290
Loan receivable from customer 329,970
(Repayment from customer and interest revenue)
Debit Credit
HK$ HK$
Impairment gains/losses 75,000
Loss allowance 75,000
(Increase loss allowance from 25,000 in previous period to 100,000)
The revised amortisation schedule is shown below.
Period Opening Cash EIM Principal Gross ECL
balance received interest reduction carrying
revenue and fee amount
amortisation
HK$ HK$ HK$ HK$ HK$ HK$
Jan 20X5 1,031,067 (372,260) 42,290 (329,970) 701,097 (100,000)
Jul 20X5 701,097 (372,260) 28,756 (343,504) 357,593 (50,000)
Jan 20X6 357,593 (372,260) 14,667 (357,593) – –
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Illustrative Example 7 (continued)
In the following months, economic conditions continue to deteriorate and the
customer begins defaulting on loans it has with its financial institutions. The customer’s
sales have decreased 50%, and the customer has begun closing down manufacturing lines
in an effort to reduce costs. The customer informs Belvue it still intends to repay the loan,
however, the customer will be unable to make the July 20X5 repayment by the due date.
Given these facts, Belvue determines the loan has become impaired and migrates it to
Stage 3. Belvue also re-estimates the lifetime expected credit losses associate with the loan
and determines the loss allowance needs to be increased to HK$500,000 on 1 July 20X5. As
informed, the customer does not make the intended payment on that date. Belvue records
the following journal entries.
Debit Credit
HK$ HK$
Impairment gains/losses 400,000
Loss allowance 400,000
(Increase the loss allowance to expected credit losses of HK$500,000)
The net carrying amount of the loan is now HK$201,097 (i.e. gross carrying amount
of HK$701,097 less allowance of HK$500,000) immediately prior to recognising interest
revenue. Without a repayment from the customer, interest revenue is capitalised into the
loan. However, because the loan is in Stage 3 of the impairment model, interest revenue
is calculated based on the net carrying amount of the loan using the original effective
interest rate.
Debit Credit
HK$ HK$
Loan receivable from customer 8,248
Interest revenue 8,248
(Interest revenue for six months based on net carrying amount of
receivable)
The intention of Illustrative Example 7 is to highlight how the expected credit loss
provision interacts with the recognition of interest revenue and how the amount of the
provision is adjusted through profit or loss. Accordingly, this example does not continue to
the conclusion of this scenario. However, Belvue would continue to assess the credit risk
associated with the customer on a periodic basis and re-estimate its expected credit losses.
Any changes to those estimates would be recognised in profit or loss as impairment gains
or losses.
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Knowledge Check Questions
Question 3
List the subsequent measurement classifications available for financial assets.
Question 4
Global Electronic Imports Limited (GEIL) acquires bonds with a face value of HK$5 million,
paying 3% interest and maturing in three years. On purchase, GEIL pays a brokerage fee of
HK$100,000, which causes the effective interest rate of the bonds to be 2.3024%. For the
remainder of the term of the bonds, the following fair values are calculated:
Year 1 Year 2 Year 3
HK$ HK$ HK$
4,950,000 5,020,000 5,000,000
Compute the fair value adjustment on the bonds in Year 1 assuming they are
subsequently measured at fair value through other comprehensive income (FVTOCI).
A (50,000)
B 70,000
C 20,000
D (117,422)
Question 5
Assume the same fair value of the bonds as described in Question 4.
Prepare all journal entries necessary to revalue the bonds on the basis that they are
measured at fair value through profit or loss.
Question 6
Compare and contrast the profit or loss and statement of financial position effects of the
fair value through other comprehensive income (FVTOCI) and fair value through profit or
loss (FVTPL) measurement requirements as it relates to bonds in Question 4 and Question
5 for Year 2 only.
Question 7
Describe the effect on an entity’s statement of financial position as a financial asset
measured at amortised cost migrates from Stage 1 of the expected credit loss model
through Stage 3.
Question 8
A bank provides an entity with a HK$1 million loan repayable in two years, charging a fixed
interest rate of 8% and upfront fees of HK$10,000 leading to an effective interest rate
of 7.4435%. The bank calculates the expected credit loss associated with this loan to be
HK$5,000. Classify the loan on initial recognition into one of the stages of the three-stage
impairment model and explain your answer.
Question 9
Using the information in Question 8, calculate and record the journal entries the bank will
recognise during the first year of the loan.
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1 2 . 4 MEASUREMENT OF FINANCIAL LIABILITIES
As shown in Exhibit 12.13, this section is still discussing measurement but now is examining
financial liabilities.
Subsequent
Contract Derecognition
measurement
Financial instrument? Initial measurement
Classification
• Financial asset
• Financial liability Recognition
• Equity instrument
• Compound instrument
EXHIBIT 12.13 Life cycle of a financial instrument
Financial liabilities are merely the opposite of financial assets. Therefore, the measurement
requirements in HKFRS 9 must be similar but without the requirements to consider the nature
of the cash flows arising from the liability and the entity’s intentions for holding the financial
liability.
12.4.1 Initial Measurement of Financial Liabilities
Similar to financial assets, financial liabilities are initially measured at fair value. If the financial
HKFRS liability is to be subsequently measured at amortised cost, the initial measurement will be
9.5.1.1 adjustment for directly attributable transaction costs paid or received.
12.4.2 Subsequent Measurement of Financial Liabilities
A financial liability is measured at amortised cost unless it is a:
• Derivative (see Section 12.9);
• Liability arising on a partial transfer of a financial asset (see Section 12.6.3);
• Financial guarantee contract (see Section 12.5);
• Below-market loan commitment at the higher of the expected credit loss allowance on
the commitment (see Section 12.3.5) and the fair value on initial recognition;
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• Designated as measured at fair value through profit or loss (see discussion of this
designation in Section 12.3.2, which applies equally to financial liabilities); or
HKFRS
9.4.2.1 • Contingent consideration within the scope of HKFRS 3 Business Combinations.
Amortised cost measurement for financial liabilities is identical to financial assets (see
Section 12.3.2.1). The only difference is that the cash flows are paid instead of received.
Where an entity designates a financial liability as measured at fair value through profit or
loss, it must present the component of the fair value change attributable to changes in the
entity’s own credit risk in other comprehensive income. Those accumulated changes are never
reclassified to profit or loss, even on disposal of the financial liability. As an exception, an entity
HKFRS
9.5.7.1, may present all changes in fair value of the liability in profit or loss (including the credit risk) if
5.7.7 doing so reduces or eliminates an accounting mismatch.
Illustrative Example 8
Belvue Electronics (Belvue) agrees to borrow HK$2 million from a bank at a fixed interest rate
of 4.5330%. Belvue agrees to repay the loan over three years in equal installments, paying
off the principal and interest in each annual payment of HK$728,000. The bank charges
Belvue an origination fee of HK$100,000, which is deducted from the funds advanced on the
drawdown of the loan. The table below shows the cash flows in respect of this arrangement.
Year 0 1 2 3
HK$ HK$ HK$ HK$
Opening balance – 2,000,000 1,362,660 696,430
Cash flow 1,900,000 (728,000) (728,000) (728,000)
Interest charged n/a 90,660 61,770 31,570
Outstanding balance 2,000,000 1,362,660 696,430 –
The cash flows above yield an effective interest rate of 7.3023%. The table below shows
the interest expense using the effective interest rate and the closing balance of the loan
at the end of each year. The interest expense is calculated as the effective interest rate
multiplied by the opening balance in each year.
Year Opening Cash paid EIM interest Principal Closing
balance expense reduction and fee balance
amortisation
HK$ HK$ HK$ HK$ HK$
1 1,900,000 (728,000) 138,744 (589,256) 1,310,744
2 1,310,744 (728,000) 95,714 (632,286) 678,458
3 678,458 (728,000) 49,542 (678,458) –
Over the life of the loan, the interest expense recognised for accounting purposes is
HK$284,000 whereas the total interest expense per the loan agreement in the first table is
HK$184,000. Therefore, over the life of the loan, Belvue recognises an additional expense
of HK$100,000 representing the origination fee. Because the origination fee is a transaction
cost integral to the loan, it is recognised over the life of the loan as opposed to a lump sum
at the beginning.
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Illustrative Example 8 (continued)
To recognise the initial loan drawdown and the first repayment, Belvue would record
the following journal entries.
Debit Credit
HK$ HK$
Cash 1,900,000
Bank loan 1,900,000
(Initial loan drawdown)
Debit Credit
HK$ HK$
Interest expense 138,744
Bank loan 589,256
Cash 728,000
(First repayment)
12.4.3 Reclassifications
HKFRS
9.4.4.2 Unlike financial assets, HKFRS 9 prohibits an entity from reclassifying financial liabilities. This
shows that financial liabilities are predominantly utilised as a source of funding as opposed to
being managed for returns or trading. Therefore, amortised cost measurement is considered
appropriate in the vast majority of cases. The exception is where an entity designates a liability
as measured at fair value through profit or loss on initial recognition to reduce or eliminate an
accounting mismatch. However, that election is only available on initial recognition.
12.4.4 Gains and Losses
Gains or losses typically arise when the entity’s estimate of future cash flows on the financial
liability change, for example, in the event of a modification of the financial liability (refer to
Illustrative Example 11 in Section 12.6.2.1). All such gains or losses are recorded in profit or loss.
1 2 . 5 FINANCIAL GUARANTEE CONTRACTS
Financial guarantee contracts are most common in the banking industry. This type of contract
requires the issuer to make specified payments to reimburse the holder for a loss it incurs
HKFRS because a specified debtor fails to make payment when due in accordance with the original or
9 App. A modified terms of a debt instrument. HKFRS 9 permits an issuer of financial guarantee
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contracts (that has previously asserted explicitly that it regards the contracts as insurance
HKFRS contracts and has accounted for them as insurance contracts) to account for the contracts in
9.2.1(e) accordance with HHKFRS 9 or HKFRS 17.
12.5.1 Initial Recognition
A financial guarantee contract that is accounted for by an issuer in accordance with HKFRS 9
is recognised as a financial liability when the guarantee is issued and is initially measured at
fair value.
The issuer may receive a premium in consideration for the issue of the financial guarantee
HKFRS contract, particularly where the guarantee was issued to an unrelated party in a stand-alone
9.B2.5 arm’s-length transaction. The issuer is less likely to receive a premium where the debtor is a
member of the same group as the issuer.
The initial measurement of the contract at fair value will depend on whether a premium
was received for the issue of the contract:
• Where the issuer receives a premium – the fair value of the instrument is equal to the
amount of the premium received; and
• Where the issuer does not receive a premium – the fair value of the instrument must be
determined using a method which quantifies the economic benefit to the holder of the
financial guarantee contract. For example, if a guaranteed loan carries an interest rate
of 6% and the same loan without a guarantee would carry an interest rate of 10%, then
the fair value of the guarantee can be determined as the present value of the difference
in interest cash flows over the life of the loan.
12.5.2 Subsequent Measurement
As with other financial liabilities, an entity may elect to designate a financial guarantee contract
at fair value through profit or loss. Where such an election is not made, a financial guarantee
contract is subsequently measured at the higher of:
• The amount of the expected credit loss allowance as determined in accordance with
HKFRS 9 (refer to Section 12.3.5); and
HKFRS • The amount initially recognised less any cumulative income recognised in accordance
9.4.2.1(c) with the principles of HKFRS 15.
Financial guarantee contracts may also arise in connection with the transfer of a financial
asset that does not result in derecognition (refer to Section 12.6.1.1). In this situation, HKFRS 9
requires an entity to measure the financial guarantee contract at the lower of the amount of
HKFRS the transferred asset or the maximum amount of the consideration received for the transfer of
9.3.2.16(a) the financial asset that the entity could be required to repay, that is, the guarantee amount.
12.5.2.1 Expected Credit Loss Allowance
As explained in Section 12.3.5, credit losses are measured at the present value of cash
shortfalls. In the case of a financial guarantee contract, cash shortfalls are determined as the
difference between the expected payments to reimburse the holder for a credit loss that it
incurs, less any amounts that the entity expects to receive from the holder, the debtor, or any
other party. So, if an asset was fully guaranteed, the estimation of cash shortfalls for a financial
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HKFRS guarantee contact would be determined on the same basis as cash shortfalls for the underlying
9.B5.5.32 asset subject to the guarantee.
The assessment of whether lifetime expected credit losses should be recognised is based
on significant increases in the likelihood or risk of a default occurring since initial recognition.
HKFRS For financial guarantee contracts, an entity considers the changes in the risk that the specified
9.B5.5.8 debtor will default on the contract.
Illustrative Example 9
At the beginning of Year 1, Belvue Electronics (Belvue) guarantees a HK$1 million loan
of its subsidiary, Velbue Electronics (Velbue). The loan was provided by Big Banking
Company (BBC) and has a term of three years and an interest rate of 4%. Interest is
payable at the end of each year and principal is repaid at the end of the loan term.
Velbue has other existing loans with BBC with similar terms which are not guaranteed.
These loans have been provided by BBC at an interest rate of 7%.
At the end of Year 1, there is a 2% probability that Velbue will default on the loan within
the next 12 months. If Velbue defaults on the loan, Belvue expects to recover 10% of the
principal amount from Velbue.
The accounting treatment and journal entries for the financial guarantee contract from
the perspective of Belvue are provided below.
Belvue (issuer) will be required to make payments to BBC (holder) to reimburse it for a
loss it will incur if Velbue (debtor) fails to make payments in accordance with the terms of
loan. This represents a financial guarantee contract, which must initially be recognised at
fair value.
In this case, the fair value of the guarantee must be determined with reference to the
present value of the difference between the contractual cash flows required under the
loan (at 4%) and the contractual cash flows that would have been required without the
guarantee (at 7%).
This can be calculated as follows:
Cash flows Cash flows Interest rate Present
at 7% at 4% differential value at 7%
HK$ HK$ HK$ HK$
Year 1 70,000 40,000 30,000 28,037
Year 2 70,000 40,000 30,000 26,203
Year 3 70,000 40,000 30,000 24,489
Total 210,000 120,000 90,000 78,729
The appropriate discount rate (7%) to be used is the interest rate at which a loan
without such a guarantee would be provided.
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Illustrative Example 9 (continued)
The financial guarantee contract will be recognised at its fair value of HK$78,729 at the
start of Year 1 through the following journal entry:
Debit Credit
HK$ HK$
Investment in subsidiary Velbue 78,729
Financial guarantee (liability) 78,729
The debit entry in this example is to Belvue’s investment in its subsidiary (as opposed
to an expense account). The guarantee represents a form of capital provided to Velbue
and, therefore, increases Belvue’s investment. If the guarantee had been provided by
Belvue to an unrelated third party, then the debit entry would have been recognised as an
expense within profit or loss.
At the end of Year 1, the financial guarantee contract must be measured at the higher
of the following amounts:
• The amount of the expected credit loss allowance. The cash flow shortfall is
determined as the difference between the expected payments to reimburse BBC
(the holder) of HK$1 million and the amount that Belvue expects to recover from
Velbue (the debtor) of HK$100,000. The expected credit loss allowance is calculated
as HK$900,000 x 2% = HK$18,000; and
• The amount initially recognised less cumulative amortisation, which amounts to
HK$54,241 determined as follows:
Opening Interest at 7% Interest cash flow Closing
balance (Effective Interest Rate) differential balance
HK$ HK$ HK$ HK$
Year 1 78,729 5,511 (30,000) 54,240
Year 2 54,240 3,797 (30,000) 28,037
Year 3 28,037 1,963 (30,000) –
Therefore, at the end of Year 1, the guarantee will be measured at HK$54,240 (as this
amount exceeds the amount of the expected credit loss allowance of HK$18,000).
The carrying amount of the guarantee is adjusted through the following journal entry:
Debit Credit
HK$ HK$
Financial guarantee (liability) 24,489
Income on financial guarantee (P&L) 24,489
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1 2 . 6 DERECOGNITION
Though the recognition requirements in HKFRS 9 are the same for financial assets and financial
liabilities, they differ significantly when it comes to derecognition, that is, when their recording
as assets or liabilities is to cease (see Exhibit 12.14). Derecognition recognises the expiration of
rights and obligations.
Subsequent
Contract Derecognition
measurement
Financial instrument? Initial measurement
Classification
• Financial asset
• Financial liability Recognition
• Equity instrument
• Compound instrument
EXHIBIT 12.14 Life cycle of a financial instrument
12.6.1 Derecognition of a Financial Asset
A financial asset is derecognised only when the contractual cash flows arising from that asset
HKFRS expire (e.g. through collection of the cash flows) or the entity successfully transfers its rights
9.3.2.3 and obligations to another entity. When considering a financial asset for derecognition,
HKFRS determining whether the derecognition requirements apply to the whole asset or only a part
9.3.2.2 thereof is important.
12.6.1.1 Transfer of a Financial Asset
HKFRS 9 provides specific requirements for when an entity transfers cash flows arising from a
financial asset to another entity. An entity may transfer cash flows by:
• Transferring the contractual right to the cash flows to another entity, or
HKFRS • Retaining the contractual rights to the cash flows while also assuming an obligation to
9.3.2.4 pay the cash flows to one or more recipients.
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Transferring the contractual rights to cash flows is often referred to as a legal transfer
because the transferee obtains legal title to those cash flows. However, performing such a
legal transfer is often costly. Therefore, entities may prefer to retain the contractual rights to
cash flows but assume a legal obligation to pay those cash flows to another party. This second
approach is often referred to as an equitable assignment.
Though a legal transfer of cash flows can be costly, it is the simplest option to account for
under HKFRS 9. Under a legal transfer, the entity is no longer party to a contract that provides
the entity with a contractual right to receive cash. Accordingly, the financial asset is
HKFRS derecognised. Any difference between the carrying amount of the transferred financial asset
9.3.2.12 and the consideration received is recognised immediately in profit or loss.
When an entity performs an equitable assignment, it needs to determine whether that
assignment meets qualifying criteria in HKFRS 9. Specifically, three conditions must be met:
1. The entity has no obligation to pay amounts to the eventual recipients unless it collects
equivalent amounts from the original asset. Short-term advances by the entity with the
right of full recovery of the amount lent plus accrued interest at market rates do not
violate this condition.
2. The entity is prohibited by the terms of the transfer contract from selling or pledging
the original asset other than as security to the eventual recipients for the obligation to
pay them cash flows.
3. The entity has an obligation to remit any cash flows it collects on behalf of the eventual
recipients without material delay. In addition, the entity is not entitled to reinvest such
cash flows except for investments in cash or cash equivalents (as defined in HKAS 7
Statement of Cash Flows) during the short settlement period from the collection date to
HKFRS the date of required remittance to the eventual recipients, and interest earned on such
9.3.2.5 investments is passed to the eventual recipients.
HKFRS If the above conditions are met, the entity needs to determine the extent to which it has
9.3.2.6 transferred the risks and rewards of ownership of the financial asset. This assessment is based
HKFRS on the entity’s exposure to variable cash flows arising from the arrangement before and after
9.3.2.7
the transfer. Often, this assessment need not be quantitative because it would be obvious that
HKFRS
9.3.2.8 all risks and rewards are transferred. For example, an entity might undertake an equitable
transfer that meets the requirements of HKFRS 9 and that contains neither credit
enhancements nor any call options for a fixed price. In this case, the entity would have
transferred substantially all risks and rewards of ownership based on a qualitative
assessment.
Where a qualitative assessment is insufficient to prove an entity has transferred
substantially all risks and rewards of ownership of the financial asset, the entity must perform a
HKFRS quantitative assessment. This assessment must reflect a probability-weighted computation of
9.3.2.8 all reasonably possible variations in net cash flows before and after the transfer.
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HKFRS If, after performing this assessment the entity has transferred substantially all risks and
9.3.2.6(a) rewards of ownership of the financial asset, the entity must derecognise it. However, if the
HKFRS entity has not retained or transferred substantially all risks and rewards of ownership of the
9.3.2.6(c) financial asset, the entity must determine whether it has retained control of the asset. The
HKFRS assessment of whether there has been a retention of control hinges on whether the transferee
9.B3.2.7 (the party acquiring the equitable interest) has the practical ability to sell the transferred asset.
If the transferee may sell the asset, then the transferor (the seller) has lost control of the asset.
On the other hand, if the transferee is restricted from selling the asset, then the transferor has
retained control. This assessment is not necessarily limited to the contractual provisions of the
transfer but must consider what the transferee can do. For example, if the transfer allows the
HKFRS transferee to sell the asset but there is no active market for that asset, then the transferee has
9.B3.2.8 not obtained control and the seller retains control.
HKFRS
9.3.2.6(c)(ii) If it is assessed that an entity retains control of the financial asset, the entity will continue to
HKFRS
recognise the financial asset to the extent of the entity’s continuing involvement in the asset. In
9.3.2.6(b) all other cases, the entity continues to recognise the transferred asset in its entirety.
Regardless of whether the transferred financial asset is ultimately derecognised, the entity
must recognise any other financial assets or financial liabilities created under the transfer
agreement. An example of such an outcome is when the entity transfers a financial asset but
charges the transferee a service fee for managing the arrangement. In this case, the entity
HKFRS recognises a financial asset if the service fee adequately compensates the entity for that service
9.3.2.10 or a financial liability where the compensation is inadequate.
Illustrative Example 10
Belvue Electronics (Belvue) ordinarily provides payment terms of 120 days to the aircraft
manufacturers to which it sells its products. Given its recent contract to produce a
significant amount of product, Belvue decides to sell the rights to future cash flows on
its receivables in an equitable transfer. This allows Belvue to obtain working capital so it
may begin ordering supplies and hire more contractors on its production line.
Belvue approaches a bank and agrees to sell the rights to all cash flows on
HK$2 million of receivables. Belvue agrees to pass on all cash it collects as soon as it
collects it and is only obliged to pass on cash flows that it receives. Assume for simplicity,
no transaction costs and that Belvue receives all of the HK$2 million from the bank in the
first instance.
Therefore, Belvue has transferred all its rights to future cash flows to the bank.
Furthermore, Belvue has not provided any guarantee or warranty concerning the
transferred cash flows; should a receivable not perform, the bank would be exposed
to any losses incurred due to that non-performance. Because Belvue is not required to
transfer any cash that it does not receive on the underlying receivables, must pass on
cash flows as soon as practicable after receiving them and provides no other guarantees,
Belvue determines that it has transferred substantially all risks and rewards to the bank.
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Illustrative Example 10 (continued)
Consequently, Belvue derecognises the receivables on receipt of consideration for the
equitable assignment from the bank by simply debiting cash and crediting receivables for
HK$2 million.
Assume, alternatively, that as part of the arrangement, Belvue also provides a credit
enhancement to guarantee the first 5% of any credit losses the bank incurs on the
receivables. In this scenario, Belvue would have continuing involvement in the transferred
assets as the guarantee would require Belvue to compensate the bank in the event the
bank needed to write off a receivable because it was uncollectible.
Now, Belvue has only transferred all risks and rewards associated with 95% of the
receivables it has sold. The remaining 5% of risks and rewards remain with Belvue
because it has guaranteed their performance to the bank. Therefore, any losses on that
5% will remain with Belvue as if Belvue kept all title to those cash flows. In this case,
HKFRS 9 permits an entity to derecognise the financial asset only to the extent it no
longer has continuing involvement with that asset (being the 5% guarantee in this case).
Additionally, HKFRS 9 requires that any additional obligations be recognised arising from
that continuing involvement in the asset, which in this case is a credit enhancement
liability.
Belvue would recognise the journal entry below:
Debit Credit
HK$ HK$
Cash 2,000,000
Receivables 1,900,000
Credit enhancement liability 100,000
(Cash received on sale, derecognition of 95% of receivables asset and recognition of
5% of the proceeds as a credit enhancement liability)
The permutations in Illustrative Example 10 are an example of the general statement
about financial instruments, that is, contracts matter because the accounting can be different
for similar transactions. Partial derecognition of a financial asset is dealt in Section 12.6.3.
Para. HKFRS 9 provides the following flowchart (Exhibit 12.15) to assist in understanding the
B3.2.1 derecognition requirements for financial assets.
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Consolidate all subsidiaries [Paragraph 3.2.1]
Determine whether the derecognition principles below are applied to a part
or all of an asset (or group of similar assets) (Paragraph 3.2.2)
Have the right to the cash flows Yes
from the asset expired? Derecognise the asset
(Paragraph 3.2.3(a))
No
Has the entity transferred its rights to
receive the cash flows form the asset?
(Paragraph 3.2.4(a))
No
Has the entity assumed an obligation to
pay the cash flows from the asset that No
Yes Continue to recognise the asset
meets the conditions in paragraph 3.2.5?
(Paragraph 3.2.4(b))
Yes
Has the entity transferred Yes
substantially all risks and rewards? Derecognise the asset
(Paragraph 3.2.6(a))
No
Has the entity retained Yes
substantially all risks and rewards? Continue to recognise the asset
(Paragraph 3.2.6(b))
No
Has the entity retained No
control of the asset? Derecognise the asset
(Paragraph 3.2.6(c))
Yes
Continue to recognise the asset to the extent of the entity’s continuing
involvement
EXHIBIT 12.15 Financial asset derecognition decision tree
12.6.1.2 Modifications of Contractual Cash Flows of Financial Assets
When the contractual cash flows of a financial asset measured at amortised cost are
renegotiated or otherwise modified and the modification does not result in the derecognition
of the financial asset, the gross carrying amount of the financial asset is recalculated and a
modification gain or loss is recognised in profit or loss. The gross carrying amount of the
HKFRS financial asset is recalculated as the present value of the modified contractual cash flows that
9.5.4.3 are discounted at the financial asset’s original effective interest rate.
12.6.2 Derecognition of a Financial Liability
HKFRS A financial liability is derecognised when the entity is discharged from its obligations under the
9.3.3.1 contract, the liability expires or is otherwise cancelled. A financial liability expires when the
entity has fulfilled its obligations under the contract, such as when a loan is fully repaid.
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If the entity compensates another party to assume the obligation, the entity may only
HKFRS
9.B3.3.1– derecognise the financial liability if it is legally released from primary responsibility of the
B3.3.5 liability from the lender. Any difference between the carrying amount of the financial liability
HKFRS and any consideration paid (including non-cash assets transferred and liabilities assumed) is
9.3.3.3 recognised immediately in profit or loss.
A discharged or cancelled financial liability may arise from similar circumstances. For
example, another entity may assume the financial liability of the original obligor. This could
happen where the entity compensates the new obligor for assuming the liability. A cancelled
liability could arise in a debt forgiveness scenario; however, this is rare.
12.6.2.1 Modification of a Bank Loan
Business needs often change, requiring the entity to reconsider its funding position. At times, it
is necessary to extend a repayment deadline for a bank loan, and at other times, an entity may
wish to expedite repayment.
Debt is often a significant consideration when an entity becomes listed on a stock
exchange, or when an entity negotiates a major new supply or other contract. In such
circumstances, modifications of debt facilities, as opposed to repayment, may be negotiated.
A modification of a financial liability needs to be assessed to determine whether it
represents a ‘substantial modification’. To determine whether the modification is substantial,
the discounted present value of the cash flows under the new terms, including any fees paid
net of any fee received and discounted using the original effective interest rate, is compared
to the present value of the cash flows of the original financial liability. In determining the fees
paid net of fees received, a borrower includes only fees paid or received between the
borrower and the lender, including fees paid or received by either the borrower or lender on
HKFRS
9.B3.3.6 behalf of the other. If the difference between these two values is at least 10%, then the
HKFRS modification is considered to be substantial. The original financial liability must be
9.3.3.2 derecognised and a new financial liability recognised.
Apply and Analyse 5
Good-For-It Limited (GFIL) has reassessed its medium-term cash flow requirements and
approaches its bank to renegotiate the terms of an existing term loan. The cash flows
of the existing loan have a present value of HK$1 million. The bank agrees to modify the
loan terms to provide GFIL with the additional medium-term cash flow it requires. No fee
is charged by the bank for this modification of the loan terms. The present value of the
modified loan, discounted using the original loan’s effective interest rate, is HK$1.15 million.
Assume the fair value of the modified loan has been determined as HK$1.1 million.
Discuss how this modification should be treated in the accounting records of GFIL.
Analysis
GFIL needs to determine whether the renegotiation of terms represents a substantial
modification of the financial liability by comparing the present value of the cash flows
under the new terms, discounted using the original effective interest rate, to the present
value of the cash flows of the existing loan.
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Apply and Analyse 5 (continued)
HK$
Present value of cash flows of existing loan 1,000,000
Present value of cash flows under new terms (at original EIR) 1,150,000
Difference 150,000 (15%)
The modification represents a substantial modification because, under the new terms,
the present value of the cash flows (discounted at the original effective interest rate) is
15% higher than the present value of the cash flows of the existing loan. Therefore, GFIL
will derecognise the existing liability of HK$1 million and recognise a new liability. The new
liability needs to be measured at its fair value of HK$1.1 million. The difference between
the carrying amount of the existing liability (HK$1 million) and the fair value of the new
liability (HK$1.1 million) will be recognised in profit or loss.
Debit Credit
HK$ HK$
Existing liability 1,000,000
Loss on extinguishment of debt (P&L) 100,000
New liability 1,100,000
If a modification does not represent a substantial modification, then the original
financial liability will not be derecognised. Instead, the entity will recalculate the carrying
amount of the liability and recognise a gain or loss in profit or loss (HKFRS 9.3.3.3). This
concept is illustrated in Illustrative Example 11.
Illustrative Example 11
At the beginning of Year 2 of the bank loan for Belvue Electronics (Belvue), it decides to
renegotiate the repayment term with the bank. Instead of the original three-year loan,
Belvue negotiates for an additional year to repay the amount outstanding, making the
loan term four years in total. As a result of the modification, the bank increases the
interest rate on the loan to 5.4918% but does not charge a fee for the modification. The
bank recalculates the annual repayments, which become HK$505,000.
At the end of Year 1, Belvue owed HK$1,362,661 on the loan, which was originally to
be paid over two years. Under the modified terms, that amount is to be repaid over three
years, illustrated below using the revised interest rate on the loan.
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Illustrative Example 11 (continued)
Year 0 1 2 3
HK$ HK$ HK$ HK$
Opening balance – 1,362,661 932,497 487,709
Cash flow 1,362,661 (505,000) (505,000) (505,000)
Interest charged – 74,836 51,212 26,291
Outstanding balance 1,362,661 932,497 478,709 –
To determine whether the new terms of the loan constitute a modification, Belvue
must determine the present value of the remaining cash flows on the original loan
compared to the new cash flows on the renegotiated loan, both discounted at the original
effective interest rate of 7.3023%.
Present value at 7.3023%
Original loan: 2 years of HK$728,000 HK$1,310,744
New loan: 3 years of HK$505,000 HK$1,317,995
Variance (HK$) 7,251
Variance (%) 0.6%
HKFRS Because the present value of the modified loan differs by fewer than 10% from the
9.B3.3.6 original loan, this modification does not qualify for derecognition. Accordingly, Belvue must
recognise the difference as an adjustment to the carrying amount of the loan with a
corresponding modification loss in profit or loss.
Belvue records the following journal entry:
Debit Credit
HK$ HK$
Modification loss 7,251
Bank loan 7,251
The loan is then amortised using the new carrying amount but the original effective
interest rate for the remaining term of the loan. The opening balance below is calculated
using the opening balance from Year 2 of the original Illustrative Example plus the
modification loss recorded above.
Year Opening Cash EIM interest Principal reduction Closing
balance paid expense and fee amortisation balance
HK$ HK$ HK$ HK$ HK$
1 1,317,995 (505,000) 96,244 (408,756) 909,239
2 909,239 (505,000) 66,395 (438,605) 470,634
3 470,634 (505,000) 34,366 (470,634) –
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If the modification of a financial liability is accounted for as an extinguishment (per Apply
and Analyse 5), any costs or fees incurred are recognised as part of the gain or loss on the
extinguishment. If the modification does not qualify for derecognition (per Illustrative
HKFRS Example 11), any costs or fees incurred adjust the liability’s carrying amount and are amortised
9.B3.3.6A over the remaining term of the modified liability.
12.6.3 Partial Derecognition
Financial assets and financial liabilities may be partly transferred or extinguished. HKFRS 9
provides specific guidance for the partial derecognition of a financial asset but does not
specifically address the partial derecognition of a financial liability.
When a financial instrument is partially transferred, HKFRS 9 requires the transfer meet one
of the following conditions:
• The part comprises only specifically identified cash flows from a financial asset
(or a group of similar financial assets), for example, when an entity enters into an
interest rate strip whereby the counterparty obtains the right to the ‘interest’ cash
flows but not the ‘principal’ cash flows from a debt instrument. This use of interest
and principal are, per legal terminology, what accounting would consider an interest
element to all cash flows over time; principal would be the discounted value of the
cash flows;
• The part comprises only a fully proportionate (pro-rata) share of the cash flows from
a financial asset (or a group of similar financial assets), for example, when an entity
enters into an arrangement whereby the counterparty obtains the rights to a 90% share
of all cash flows of a debt instrument. If there is more than one counterparty, each
counterparty is not required to have a proportionate share of the cash flows provided
the transferring entity has a fully proportionate share; and
• The part comprises only a fully proportionate (pro-rata) share of specifically identified
cash flows from a financial asset (or a group of similar financial assets), for example,
when an entity enters into an arrangement whereby the counterparty obtains the rights
to a 90% share of interest cash flows from a financial asset. If there is more than one
counterparty, each counterparty is not required to have a proportionate share of the
HKFRS specifically identified cash flows provided the transferring entity has a fully
9.3.2.2(a) proportionate share.
If any of the preceding conditions are met for the part of the financial instrument
transferred, the derecognition requirements of HKFRS 9 will apply to that part only.
The partial derecognition of a financial asset was illustrated in Section 12.6.1. The next
exercise considers the partial derecognition of a financial liability.
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Apply and Analyse 6
Belvue Electronics (Belvue) has a loan from a bank totalling HK$50 million, repayable in
full in two years. As part of Belvue’s review of funding sources, the financial controller
determines that half of the funding should be repaid immediately with the proceeds from
a capital raising through the Hong Kong Stock Exchange (HKEx). However, the bank loan
does not permit Belvue to prepay any part of the loan. The financial controller decides
to compensate a third party (HK Debt Managers) to assume the liability for a 10% fee.
The financial controller contacts the bank to confirm that Belvue will be released from
its primary obligation with respect to the 50% transferred to a third party. Unfortunately,
the bank informs Belvue that because it is not permitted to prepay any part of the loan,
the bank cannot provide any kind of legal release. Determine if the transaction meets the
derecognition criteria for a financial liability. Identify whether your response would change
if the bank did provide legal release.
Analysis
In the first instance, Belvue is not applying the derecognition criteria to the whole of
the financial liability because it only intends to transfer half of it. Accordingly, the partial
derecognition criteria are applicable. The financial controller acknowledges that HKFRS
9 does not contain any specific guidance for identifying whether a part of a financial
liability is derecognised but notes that paragraph 3.3.1 of HKFRS 9 does refer to the partial
derecognition of financial liabilities. As such, the financial controller applies the partial
derecognition criteria for financial assets.
In this case, Belvue wishes to transfer 50%, being HK$25 million, of the financial
liability to another entity in compensation for a 10% fee. Given that the transferred portion
represents a fully proportionate share of the financial liability, the financial controller
may apply the derecognition criteria to that portion. Based on the information from the
bank, Belvue will remain the primary obligor for the 50% of the debt despite another party
agreeing to make payments on Belvue’s behalf. As a result, the derecognition criteria
for the 50% of the financial liability transferred are not satisfied, and Belvue continues
to recognise the loan in full. If Belvue decides to continue with the arrangement, it will
recognise HK$250,000 as an expense in profit or loss for the fee paid to the third party.
If the bank had provided legal release, the 50% of the loan transferred would be
derecognised. The fee paid to the third party would still be recognised in profit or loss
because it is the excess of compensation paid for the liability transferred.
Knowledge Check Questions
Question 10
An entity agrees to sell an equitable interest in future cash flows associated with a portfolio
of financial assets for HK$1 million. However, the agreement includes an obligation on the
entity to repurchase the rights to cash flows at a specified future date for a fixed amount of
cash. Determine whether the entity has transferred substantially all risks and rewards on a
qualitative basis.
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Knowledge Check Questions (continued)
Question 11
Using the same facts as in Question 10, except that the entity’s obligation is to repurchase
the rights to cash flows at fair value, determine whether your assessment of the transfer of
risks and rewards has changed and justify your answer.
Question 12
An entity renegotiates half of its bank loan on terms and conditions that result in the
change in the present value of the renegotiated loan exceeding 10% of the original loan.
Explain the outcome of the derecognition requirements on this event.
1 2 . 7 TREASURY SHARES
Treasury shares are equity instruments an entity holds that represent an equity interest in
itself. Treasury shares do not represent an asset of the entity because the contract that the
share represents has only a single party involved. In other words, the share requires the entity
to pay dividends to itself and entitles the entity to a proportionate share in the net assets of
itself. As such, the share does not create a financial asset or a financial liability of another
HKAS entity. HKAS 32 makes this conclusion explicit by stating that a treasury share is not a financial
32.AG36 asset of the entity. Instead, it is a reduction of the equity held by external parties.
HKAS When an entity acquires, reissues, or cancels treasury shares, the transaction must
32.33 be recorded directly in equity because the transaction represents one with the owners of the
HKAS
entity and, therefore, is not in the nature of the entity’s ordinary business. Consequently, no
32.AG36 gain or loss can arise from an entity acquiring, cancelling, or reissuing treasury shares.
1 2 . 8 COMPOUND FINANCIAL INSTRUMENTS
MEASUREMENT
Some contracts combine the elements of financial liabilities and equity instruments. For
example, a contract may require an entity to make fixed payments to the holder but permit the
holder to exchange that cash flow stream for a fixed amount of the entity’s equity instruments.
The most common example of this type of instrument is a convertible bond.
HKAS When an entity issues a compound instrument, HKAS 32 requires the entity to separate the
32.28 instrument into separate financial asset, financial liability and equity instrument components.
The accounting for each component then follows the separate requirements for that particular
type of financial instrument.
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This section covers the additional classification step (as shown in Exhibit 12.16) because
a compound instrument is a single contract that must be split into its constituent parts. The
accounting requirements for the separate components of a compound financial instrument
have been covered in earlier sections.
Subsequent
Contract Derecognition
measurement
Financial instrument? Initial measurement
Classification
• Financial asset
• Financial liability Recognition
• Equity instrument
• Compound instrument
EXHIBIT 12.16 Life cycle of a financial instrument
12.8.1 Convertible Instruments that Are Not Compound Instruments
The fact that an instrument may be settled in the entity’s own equity instruments does not
automatically result in that instrument being a compound instrument. The definition of a
financial liability, discussed in Section 12.1.3, refers to the number of equity instruments to be
issued in exchange for settling a liability. That definition requires that any instrument settled
with a variable number of shares will be classified as a financial liability in totality.
Instruments that are not compound instruments typically include the following features:
• The instrument may be converted for a variable number of shares equal to the value
outstanding on the debt instrument; and
• The instrument is denominated in a foreign currency so the number of shares required
to settle the instrument is variable dependent on foreign exchange rates.
12.8.1.1 Fixed-for-fixed Requirement
The fixed-for-fixed test is fundamental to classifying financial instruments as financial liabilities,
equity or compound instruments. If an entity may be required to settle a fixed obligation with a
fixed number of shares, the instrument will have equity features. The central rationale behind
the test is to consider the economic value the instruments issuer must transfer to settle an
obligation. If the entity must exchange an economic value equal to the obligation, then the
instrument is classified as a liability. Given that share prices move over time, to settle a fixed
obligation, the entity will need to vary the number of equity instruments it transfers to transfer
a fixed economic value. Therefore, an instrument that may require settlement of a fixed
obligation in exchange for a variable number of shares is classified as a financial liability.
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Exhibit 12.17 summarises the classification of a financial instrument that can be settled
in equity:
Is the contract a
non-derivative or a derivative?*
Derivative Non-derivative
Fixed for fixed test: Can the
derivative be settled other
Fixed test: Is the entity, or
than by the exchange of a
may the entity be, obliged
fixed amount of cash or
to deliver a variable number
another financial asset for a
of its own equity instruments?
fixed number of the entity’s
own equity instruments?
Yes No Yes No
Financial liability Equity Financial liability Equity
EXHIBIT 12.17 Classifying a financial instrument with equity settlement
Illustrative Example 12
Belvue Electronics (Belvue) intends to raise capital through the issue of a convertible
bond. The total proceeds sought from the issue amount to HK$5 million. The bond will
pay 5% fixed coupons and will mature in three years unless converted to equity at the
option of the holder at any time prior to maturity.
Belvue is considering whether the debt should be convertible for a fixed number of
equity instruments or a variable number of equity instruments that in sum will be valued
equal to the outstanding principal. To assist in classification, the financial controller
prepares the table below that ascribes exposure to variable economic value to the issuer
or the holder depending on the terms of the conversion feature.
Number of equity Share price (HK$) Economic value
instruments to holder (HK$)
Fixed
5,000,000 1.0 5,000,000
5,000,000 0.5 2,500,000
Variable
5,000,000 1.0 5,000,000
10,000,000 0.5 5,000,000
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Illustrative Example 12 (continued)
Using the above example, ascribing a fixed number of shares as the conversion
outcome exposes the holder of the instrument to a variable economic return. Conversely,
if a variable number of shares is ascribed, the economic return to the holder of the
instrument is fixed because Belvue would be required to exchange a certain number of
shares that on conversion will equal the amount of principal outstanding on the bond.
Belvue’s financial controller concludes that the instrument will be classified as a
financial liability in its entirety if the instrument is convertible for a variable number of
shares. On the other hand, the instrument would be a compound instrument if it may be
convertible for a fixed number of shares.
12.8.2 Split Accounting: Initially and Subsequently
With an instrument that may be settled in cash or an entity’s own equity instruments that are
HKAS not classified as a financial liability in its entirety, HKAS 32 requires the entity to account for
32.28 the liability and equity components separately. The liability component is determined by
calculating the fair value of the obligation to transfer cash flows, which is usually determined
on a present value basis with reference to the return of a similar instrument that does not
HKAS include the conversion option. This amount is deducted from the transaction price, and the
32.31, 32 residual is allocated to the equity component. The sum of the liability and equity components
will always equal the transaction price of the instrument using this approach. Any transaction
costs incurred in issuing the compound instrument are allocated to the liability and
HKAS equity components in the same proportion as the liability and equity components are split
32.38 as above.
Subsequently, the liability component is measured as a financial liability in accordance
with HKFRS 9 using an effective interest rate of an equivalent instrument that does not have
the conversion feature (see Section 12.4.2). The equity component, however, is never
HKAS remeasured, irrespective of any changes in the likelihood of the conversion option being
32.30 exercised. If the instrument is converted into equity, the carrying amount of the instrument at
the time of conversion is recognised in equity to represent the issue of equity to extinguish
the liability.
Illustrative Example 13
Belvue Electronics (Belvue) decides to issue a convertible bond as described previously
with an option for the holder to convert the instrument into a fixed number of equity
instruments at any time up to maturity. Accordingly, the instrument must be accounted for
as a compound instrument. In addition to the information previously presented, Belvue
determines that a similar instrument without a conversion feature would pay 8% annual
coupons. In issuing the instrument, Belvue incurs transaction costs of $80,000. The liability
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Illustrative Example 13 (continued)
component of the convertible bond is determined using that 8% rate as the discount rate.
This calculation yields a present value of HK$4,613,435. This is the initial measurement
of the liability component. The residual of HK$386,565 represents the value of the equity
conversion feature and is recognised in equity. To allocate the $80,000 transaction costs,
Belvue calculates the proportion of the proceeds allocated to the liability and equity
components and allocates the costs accordingly. For example, the amount allocated to the
liability component is HK$73,815 (HK$4,613,435/HK$5,000,000 x HK$80,000). The initial
recognition of the convertible bond is presented in the journal entry below.
Debit Credit
HK$ HK$
Cash 4,920,000
Convertible bond liability 4,539,620
Equity 380,380
(Initial recognition of convertible bond: compound instrument less transaction costs incurred)
The carrying amount of the convertible bond becomes the carrying amount for
the purpose of amortised cost measurement as described in Section 12.4.2. Given the
transaction costs allocated to the liability component, the effective interest rate of the
liability becomes 8.6124%. The following journal entry illustrates recognising interest
expense in the first year and the accrual of the present value of the discount associated
with the equity conversion option. The cash interest paid is calculated based on 5% of the
face value of the bonds and not the carrying amount for accounting purposes. However,
the interest expense is calculated based on the effective interest rate of 8.6124% on the
accounting carrying amount.
Debit Credit
HK$ HK$
Interest expense 390,970
Convertible bond liability 140,970
Cash 250,000
(Year 1 interest payment and discount accrual)
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Knowledge Check Questions
Question 13
InvestiCoin Limited (InvestiCoin) issues 1,000 convertible bonds with a face value of
HK$100 each, discretionary annual coupon payments of 3%, a four-year maturity and
the option for the holder to convert the instrument to 10 equity shares of InvestiCoin per
bond. InvestiCoin is a start-up company, and share prices are expected to increase at an
annual growth rate of 50% from a current price of HK$3. Determine the year in which it
becomes advantageous for a holder to convert the instruments to equity.
Question 14
The instrument in Question 13 would be classified entirely as equity. Explain why HKAS 32
adopted this approach for instruments that meet the fixed-for-fixed test.
Question 15
Assume instead that the coupons for the instrument in Question 13 were mandatory
contractual payments. Assume that a similar bond would pay a coupon of 6%. The present
value of the liability component is HK$89.61 per bond. Prepare journal entries for the initial
recognition of the bonds and their first interest payment.
1 2 . 9 DERIVATIVES
Derivatives, much like their mathematical namesake, derive their value from another variable.
A derivative will always refer to another asset, liability, or event from which the derivative
instrument gains its value to an entity. Using this description, financial instruments are primary
instruments (which have been discussed up to this point) or derivative instruments. A primary
instrument has value because of the cash flows it generates as a result of an exchange of value
at contract commencement. Derivative instruments do not require any substantial exchange of
value at commencement but define future cash flows with reference to other instruments.
Derivatives are also volatile because their value may vary over time and even switch from
a net receipt of cash to a net payment of cash and back again prior to maturity. Derivatives are
‘leveraged’ instruments because they require almost no initial investment but their cash flow
requirements over time may be multiples of that initial investment.
Derivatives are unique in that a single derivative might be a financial asset in one reporting
period and a financial liability in another. Which of these derivatives are presented depends on
market movements that affect the derivatives. Therefore, as illustrated in the life cycle graphic
(Exhibit 12.18), the classification of a derivative as a financial asset or a financial liability is an
ongoing exercise.
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Subsequent
Contract Derecognition
measurement
Financial instrument? Initial measurement
Classification
• Financial asset
• Financial liability Recognition
• Equity instrument
• Compound instrument
EXHIBIT 12.18 Life cycle of a financial instrument
HKFRS 9 defines a derivative as a financial instrument with all three of the following
characteristics:
1. 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, provided that the variable is not specific
to a party to the contract in the case of a non-financial variable;
2. 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; and
3. It is settled at a future date.
12.9.1 Derivative Financial Instruments
HKFRS
9.4.1.4,
HKFRS HKFRS 9 requires all derivatives to be measured at fair value through profit or loss, unless they
9.4.2.1 form part of an effective hedge relationship (see Chapter 13). Common examples of
derivatives include:
• Forwards: A contract to buy or sell an asset at a fixed price at a future date, typically
traded in an over-the-counter market;
• Futures: Similar to forwards; however, standardised and traded on exchanges (for
e.g. futures exist for commodities, such as gold, silver and iron);
• Options: A contract that provides a party with the option, but not the obligation, to
purchase or sell an asset at a future date for a fixed price; and
• Swaps: Parties who agree to exchange a series of cash flows (usually exchanging foreign
currency or interest cash flows).
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Using the definition of derivatives, they have little or no initial net investment. Any net
investment upfront would be minor in comparison to the exposure the entity obtains from
entering into that derivative contract. For example, on an interest rate swap, an entity might
agree to exchange fixed interest payments with floating interest payments on a notional
amount of HK$5 million. On Day 1, the obligation to pay fixed interest payments to the
counterparty is equal to, and the opposite of, the right to receive floating interest payments
from the same counterparty; in other words, the derivative is ‘at market’. However, over time,
the fair value of the pay-fixed leg will vary in comparison to market rates. That variance will be
multiplied by the notional amount of the contract. Therefore, a 1% move in interest rates could
have a HK$50,000 impact on profit or loss.
Apply and Analyse 7
Belvue Electronics (Belvue) currently has a loan paying 6% fixed interest on a borrowed
amount of HK$5 million for a remaining term of three years. If Belvue were to borrow that
same amount in the current market, it would be able to negotiate an interest rate of 4%;
Belvue thinks those market rates are likely to decrease further. Instead of renegotiating its
loan with the bank, Belvue decides to enter into an interest rate swap with another bank
whereby it pays the second bank a floating rate of interest in exchange for receiving a fixed
rate of interest equal to the amount Belvue pays its lender. In combination with the fixed
interest payments on the loan, Belvue would be exposed to a variable rate of interest. On
entering the contract, the present value of the remaining interest cash flows is HK$832,527;
this would become the ‘receive leg’ on the derivative from Belvue’s perspective. To ensure
the derivative is ‘at-market’ on this day, the counterparty computes a variable rate of
interest that would apply to the ‘pay leg’ to ensure the net present value of the derivative is
zero. Using software, the counterparty determines this rate to be 6.26%, which this means
the interest rate is comprised of the market rate of 4% plus a rate specific to Belvue of
2.26%. This is essentially the same process as determining the effective interest rate on an
amortised cost financial asset (see Section 2.3.2.1). The table below shows the market rate
and present values of the pay leg and receive leg of the derivative at the beginning of the
three years.
Year 1 2 3
Market rate 4% 2% 3%
(Pay float leg) HK$ (832,527) (413,456) (255,292)
Receive fixed leg HK$ 832,527 582,468 291,262
Net asset/(liability) HK$ – 169,012 35.970
Compare and contrast the nature of this interest rate swap from the nature of
the fixed rate loan Belvue is paying off. Use your answer to contrast the statement
of financial position consequences of using a derivative to gain exposure to variable
interest rates as opposed to renegotiating the loan for a variable interest rate; assume
the renegotiation is a substantial modification and the new loan would be measured at
amortised cost.
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Apply and Analyse 7 (continued)
Analysis
The interest rate swap in this example uses the same interest rate (6%) as the loan on its
receive leg. This receive leg matches the loan interest payments in every way, effectively
eliminating Belvue’s fixed interest payment on the loan. This is where the similarities
end. The pay leg on the interest rate swap has no counterpart on the original loan, and
the only characteristic that compares is that payments are based on the same amount
outstanding on the loan (HK$5 million). The pay leg incorporates the market rate of 4% on
commencement and includes an adjustment of 2.26%, which is specific to Belvue to ensure
the present value of the pay leg matches the receive leg. This ensures the initial value of
the derivative is zero on initial recognition. Over time, as market rates move, the cash flows
on the receive leg remain constant (albeit discounted at the prevailing market rate) while
the cash flows on the pay leg are varying with market rate movements. This means the two
legs no longer offset each other and give rise to a net present value on the statement of
financial position as seen in the preceding table. Any movements during the year in market
interest rates add an element of volatility to the net present value of the derivative, which
is taken immediately to profit or loss. In contrast, the loan payable has no volatility and
simply results in a steady interest expense recognised in profit or loss and amortises any
transaction costs included in its balance.
If Belvue had instead renegotiated the loan to a variable rate, it would have been able
to avoid the fair value volatility of the derivative on its statement of financial position while
being exposed to its desired variable interest rates. However, any difference in the carrying
amount of the original fixed rate loan and the new variable rate loan would have been
recognised in profit or loss upon renegotiation.
Illustrative Example 14
Belvue Electronics (Belvue) enters into a forward agreement to purchase EUR10 million in
exchange for HK$80 million in 60 days. Belvue determines that this instrument qualifies
as a derivative under HKFRS 9 because:
• The forward agreement does not require any upfront investment;
• The value of the forward will fluctuate in response to the HK$/EUR exchange rate
over time; and
• The forward agreement is settled in the future.
Based on this agreement, the forward rate is HK$8 = EUR1. Given this agreement
is transacted at market rates prevalent on the day, it has zero value. The table below
illustrates the change in spot exchange rates over the 60-day period:
Day Spot HK$ EUR Fair value of
(HK$/EUR) derivative
0 8.0 80,000,000 10,000,000 –
30 7.2 72,000,000 10,000,000 (8,000,000)
60 8.1 81,000,000 10,000,000 1,000,000
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Illustrative Example 14 (continued)
On Day 30, the exchange rate improves so only HK$72 million is required to purchase
EUR10 million. However, because Belvue has a contract to purchase that EUR amount for
HK$80 million, the forward has entered into a liability position because it is unfavourable
compared to current market rates. Similarly, when the exchange rate deteriorates, the
forward enters a favourable position compared to market rates. The fair value movements
with respect to the nil upfront investment illustrate the leveraged nature of derivatives and
how they obtain their value with reference to a variable.
The journal entries Belvue would be required to record are illustrated below. No entry
is recorded on Day 0 because the derivative has no initial value.
Debit Credit
HK$ HK$
Fair value movement on derivative (P&L) 8,000,000
FX forward contract 8,000,000
(Day 30 fair value loss on the forward)
On Day 30, the foreign exchange (FX) forward contract would be presented as a
financial liability in the statement of financial position because the contract results in an
obligation to exchange financial assets (i.e. cash in EUR or HK$) with another entity under
unfavourable conditions.
Debit Credit
HK$ HK$
FX forward contract 9,000,000
Fair value movement on derivative (P&L) 9,000,000
(Fair value gain between Day 30 and Day 60)
Debit Credit
HK$ HK$
Euro bank account (in HKD) 81,000,000
FX forward contract 1,000,000
HK Dollar bank account 80,000,000
(Settlement of forward contract at 60-day spot rate)
In the final journal entry, the Euro bank account shows an HK$ value of the
EUR10 million received at the spot rate on Day 60. However, the contract still only requires
the payment of HK$80 million; therefore, the difference is essentially ‘contributed’ from
the FX forward contract. Forward contracts and derivatives are used extensively in hedge
accounting, see Chapter 13.
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12.9.2 Simple Embedded Derivatives
An embedded derivative is a component of a contract that also includes a non-derivative host,
with the effect that some of the cash flows of the combined instrument vary in a way similar to
HKFRS a stand-alone derivative. An embedded derivative causes some or all of the cash flows that
9.4.3.1 otherwise would be required by a contract to be modified.
The ‘host contract’ that includes an embedded derivative need not be a financial instrument
itself. Host contracts may include:
• Leases;
• Sale or purchase contracts;
• Insurance contracts; and
• Financial instruments.
If a contract is a financial asset within the scope of HKFRS 9, an entity will apply the
HKFRS classification and measurement requirements (see Sections 12.2 and 12.3) to the entire
9.4.3.2 contract, including any embedded derivative. In other words, there is no need to separate the
embedded derivative from the host contract and to account for each instrument separately.
For any contract, which is not a financial asset, an entity must consider whether any
embedded derivatives need be separated from the host contract and accounted for as
derivatives under HKFRS 9. An embedded derivative must be separated if:
• The economic characteristics and risks of the embedded derivative are not closely
related to the economic characteristics and risks of the host contract;
• A separate instrument with the same terms as the embedded derivative would meet
the definition of a derivative; and
HKFRS • The whole contract has not been designated to be measured at fair value through
9.4.3.3 profit or loss.
For example, assume a start-up company is seeking to raise funds from venture capital
investors. The company issues issue a bond (host contract), which requires periodic interest
payments and the repayment of principal and entitles the investor to receive ordinary shares
if the company subsequently lists on the stock exchange; this feature is commonly called an
equity kicker. As a result of this feature, the interest on the loan is lower than it would have
been, and this feature represents an embedded derivative as the economic characteristics
and risks of an equity return are not closely related to those of the host debt instrument. The
feature meets the definition of a derivative because its value changes in response to the change
in the price of the company’s shares, and it requires a relatively small initial net investment and
it is settled at a future date.
Assuming the issuer does not elect to designate the entire bond at fair value through profit
or loss, the embedded derivative is required to be separated from the bond. The derivative will
subsequently be measured at fair value through profit or loss, and the bond will be measured
at amortised cost.
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Apply and Analyse 8
Belvue Electronics (Belvue) enters into a contract to purchase raw materials from an entity
based in mainland China. (Ignore the own-use exemption for the purposes of this example
(see Section 12.9.3). Because Belvue is unable to prove it manages this contract with other
financial instruments, it cannot designate the financial liability as measured at fair value
through profit or loss to reduce an accounting mismatch. The contract requires payment
in British Pounds Sterling (GBP), which is not the functional currency of the supplier or
Belvue (see Chapter 31 for a discussion of functional currency). The raw materials being
purchased are ordinarily paid for in US dollars (USD). Determine whether the requirement
to pay in GBP creates an embedded derivative.
Analysis
The first step in determining whether the financial liability contains an embedded
derivative requires Belvue to determine whether the requirement to pay in GBP is closely
related to the overall contract. Ordinarily, this type of contract is settled in USD, but this
does not necessarily mean the requirement to pay in GBP is not closely related to the
contract. However, neither the supplier nor Belvue are ordinarily exposed to GBP in
contracts of a similar nature. Accordingly, Belvue determines that the characteristics of
the requirement to pay in GBP is not closely related to the agreement to purchase raw
materials because neither party is ordinarily exposed to GBP foreign exchange risk for
purchases of this type.
When further considering if the embedded derivative should be separated, Belvue
notes that contracts to acquire GBP in exchange for Hong Kong Dollars (HKD) are traded
on the market and meet the definition of a derivative.
In consideration of all these facts, Belvue has a purchase contract for the raw materials
and an embedded foreign currency forward to acquire GBP. The embedded forward
is separated from the host contract and accounted for as a derivative (see Illustrative
Example 14 in Section 12.9.1, which further illustrates the accounting for a stand-alone
foreign currency forward).
Illustrative Example 15
Gold Digger Company (GDC) issues a commodity-linked bond with a face value of
HK$1 million, repayable in three years’ time. Interest is payable annually and consists of
a guaranteed interest rate of 4% and contingent interest of an additional 1% if the price
of gold increases by more than HK$300 per ounce in the relevant year or of an additional
2% if the price of gold increases by more than HK$500 per ounce in the relevant year.
GDC could have issued a bond without the contingent interest feature at a fixed interest
rate of 5%.
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Illustrative Example 15 (continued)
The bond (host contract) represents a financial liability from the issuer’s perspective, so
GDC is required to consider whether any embedded derivatives need to be separated from
the host contract. The commodity linked feature in essence represents a swap contract to
‘receive’ 1% fixed interest (i.e. the interest ‘saving’ being the difference between the 5% that
the bond would otherwise have been issued at and the 4% guaranteed interest rate) and
to pay variable interest (depending on the price of gold). This swap meets the definition of
a derivative because its value changes in response to the change in a specified commodity
price (the price of gold); it requires a relatively small initial net investment and it is settled
at a future date (each annual interest payment date).
HKFRS 9 does not define what is meant by ‘closely related’. However, the economic
characteristics and risks of the embedded swap (which are driven by the gold price) are
not closely related to the economic characteristics and risks of the bond (which are driven
by the credit risk of the issuer). Assuming that GDC does not elect to designate the entire
bond at fair value through profit or loss, the embedded swap is required to be separated
from the bond.
The host instrument represents a fixed-rate debt instrument that pays interest at 4%.
HKFRS 9 specifies that the initial carrying amount of the host instrument is the residual
amount after separating the embedded derivative. Therefore, at initial recognition, it
is necessary to determine the value of the embedded swap. In this example, the swap
represents a non-option derivative and will have a fair value of zero at initial recognition.
Consequently, the host contract will initially be measured at the full fair value of the
instrument. The derivative will subsequently be measured at fair value through profit or
loss, and the bond host contract will be measured at amortised cost.
Assume the initial fair value of the bond (including the embedded swap) is HK$980,000
and the appropriate effective interest rate to use for the subsequent measurement of the
host contract is 4.731%. At the end of Year 1, the gold price has increased by HK$520 per
ounce, so GDC is required to pay 2% interest in addition to the guaranteed interest rate of
4%. Assume further that the fair value of the derivative at the end of Year 1 (after interest
has been settled) is HK$100,000.
GDC would record the following journal entries in Year 1:
Debit Credit
HK$ HK$
Cash 980,000
Bond liability 980,000
Derivative liability –
(Separate recognition of bond liability and derivative on issuance)
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Illustrative Example 15 (continued)
Debit Credit
HK$ HK$
Interest expense (P&L) 46,361
Bond liability 6,361
Cash 40,000
(Measurement of bond liability at amortised cost using effective interest
rate of 4.731% and payment of fixed interest at 4% on HK$1 million)
Debit Credit
HK$ HK$
Fair value loss on derivative (P&L) 120,000
Cash 20,000
Derivative liability 100,000
(Measurement of derivative liability at fair value through profit or loss and
payment of contingent interest of 2% on HK$1 million)
12.9.3 Application of Own-use Exemption
HKFRS 9 provides an exemption where entities enter into financial instruments for the purpose
HKFRS 9.2.4,
HKFRS 7.5, of the receipt or delivery of a non-financial item in accordance with the entity’s expected
HKAS 32.8 purchase, sale, or usage requirements (commonly referred to as the own-use exemption). For
example, Belvue routinely enters into contracts to acquire raw materials for a fixed price at a
future date for use in manufacturing its products. These contracts are called own-use contracts,
or sometimes executory contracts. HKFRS 9 provides a recognition exemption for such
contracts so entities are not required to recognise them until the actual cash flows occur as
with an ordinary sale or purchase. Nevertheless, an entity may elect to measure an own-use
HKFRS contract at fair value through profit or loss at inception of the contract if doing so will eliminate
9.2.5 or significantly reduce an accounting mismatch.
Knowledge Check Questions
Question 16
Identify three key features of a derivative that distinguish it from a non-derivative financial
instrument.
Question 17
Belvue enters a contract to sell a portfolio of receivables to a bank in mainland China. The
receivables are denominated in Hong Kong dollars (HKD), but the contract will be settled in
Chinese Yuan, the functional currency of the purchaser. Determine whether the contract
contains an embedded derivative that must be separated.
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1 2 . 1 0 DISCLOSURE
The classification and measurement requirements discussed previously in this chapter require
the use of significant judgements, estimates and potentially volatile inputs that can affect an
entity’s financial statements in the current and future periods. For this reason, the objective of
HKFRS 7 is to require entities to provide disclosures in their financial statements that enable
users to evaluate:
• The significance of financial instruments for the entity’s financial position and
performance; and
• The nature and extent of risks arising from financial instruments to which the entity is
HKFRS exposed during the period and at the end of the reporting period and how the entity
7.1 manages those risks
12.10.1 Statement of Financial Position Disclosures
HKFRS 7 requires an entity to disclose the carrying amounts of financial instruments separately
by classification in accordance with HKFRS 9 (see Sections 12.2, 12.3 and 12.4). Specifically,
HKFRS 7 requires separate disclosure on the statement of financial position of:
• Financial assets measured at fair value through profit or loss, showing separately those
designated as such on initial recognition and those that are mandatorily measured as
such (e.g. derivatives);
• Financial liabilities measured at fair value through profit or loss, showing separately
those designated as such on initial recognition and those that meet the definition of
held for trading;
• Financial assets measured at amortised cost;
• Financial liabilities measured at amortised cost; and
• Financial assets measured at fair value through other comprehensive income (FVTOCI),
showing separately (1) those assets that have cash flows characterised as solely
payments of principal and interest where the entity intends to realise the asset through
collection of contractual cash flows or sale, and (2) those equity instruments measured
at FVTOCI (para. 8).
Separating financial assets and liabilities in the manner required above allows a user
of the financial statements to gain an understanding of the cash flow characteristics of the
instruments, the entity’s business model for holding them and some of the risks that attached
to those instruments. To assist a user to further understand the types of instruments an entity
holds, the following additional disclosures are required:
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• For financial instruments measured at fair value through profit or loss, disclose
primarily the effect of credit risk on that measurement. For financial assets, this
HKFRS includes the effect of any credit derivatives that may help to mitigate the effect of credit
7.9–11 risk. These disclosures help a user to understand the extent to which fair value changes
are attributable to market movements or to the credit risk of the underlying instrument.
Deterioration in credit risk (especially when a deterioration is significant) may indicate
an increased probability that the instrument is no longer collectible;
• For equity instruments designated as measured at FVTOCI, the entity must disclose its
HKFRS reasons for making that election. Additionally, the entity must disclose any dividends
7.11A – 11B received, and if the entity disposed of the investment, the reason for doing so. These
disclosures are necessary because the option to designate an equity investment at
FVTOCI is only available where those instruments are not held for trading (see
Section 12.1.3). Therefore, any disposals should not be undertaken primarily for the
purpose of realising a gain. If that were the case, the entity should have measured the
equity instruments at fair value through profit or loss;
HKFRS • The reasons for any reclassifications of an instrument between the HKFRS 9
7.12B – 12D measurement categories; ;
HKFRS • Information to enable users of the financial statements to evaluate the effect, or potential
7.13A – 13F effect, of netting arrangements on the entity’s financial position. Qualifying netting
arrangements permit an entity to present certain financial assets and financial liabilities
on a net basis in the entity’s statement of financial position. Any offsetting of this manner
does have the potential to reduce the information usefulness of the entity’s financial
statements. Accordingly, HKFRS 7 requires an entity to separately disclose in the notes to
the financial statements the gross position of the netted financial instruments; and
• Information about collateral held or pledged during the reporting period, the allowance
for credit losses associated with financial assets measured at FVTOCI, compound
HKFRS financial instruments with multiple embedded derivatives and any defaults or breaches
7.14 – 19 on the entity’s loans payable.
Illustrative Example 16
A hedge fund enters into a large number of derivative agreements with various
counterparties that are subject to enforceable netting arrangements. Some of these
arrangements meet the requirements of HKAS 32 to be presented net on the statement
of financial position, and others do not.
The hedge fund makes the following disclosure, consistent with the requirements
of HKFRS 7.
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Illustrative Example 16 (continued)
HK$m
(a) (b) (c) = (a) – (b) (d) (e) =
(c) – (d)
Related amounts not set
off in the statement of
financial position
Gross Gross Net Financial Cash Net
amounts of amounts amounts instruments collateral amount
recognised of financial of financial received
financial liabilities set assets
assets off in the presented
statement of in the
financial statement
position of financial
position
HK$m HK$m HK$m HK$m HK$m HK$m
Description
Derivatives 200 (80) 120 (80) (30) 10
Reverse 90 - 90 (90) - -
repurchase,
securities
borrowing
and similar
arrangements
Other financial - - - - - -
instruments
Total 290 (80) 210 (170) (30) 10
The disclosure helps users to understand the entity is ultimately exposed to risks
arising from HK$210 million in the ordinary course of business due to its netting
arrangements, but in any other event, the risk is limited to HK$10 million.
12.10.2 Statement of Profit or Loss and Other Comprehensive Income
Disclosures
HKFRS 7 also prescribes certain disclosures to be made in the statement of comprehensive
income or in the notes:
• Net gains or losses separately on financial instruments measured at fair value through
profit or loss, amortised cost or fair value through other comprehensive income (FVTOCI);
• Total interest revenue and total interest expense, separately, for those instruments
measured at amortised cost or FVTOCI; and
HKFRS
7.20) • Fee income and fee expense.
12.10.3 Other Disclosures
In the summary of material accounting policy information, entities must disclose the
HKFRS measurement basis used in preparing the financial statements and the other accounting
7.21 policies relevant to an understanding of the financial statements.
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HKFRS Furthermore, entities must disclose the fair value of financial assets measured at amortised
7.25 cost so users may compare their carrying amounts with their fair values. When making this
(HKFRS disclosure, an entity can group financial assets and liabilities into classes of similar instruments
7.26) but may not apply offsetting unless it is otherwise permitted in HKAS 32. However, this
(HKFRS disclosure is not required where the carrying amount of the instrument approximates fair value
7.29) and for lease liabilities. A common example of where the carrying amount of a financial
instrument approximates its fair value is for floating-rate loans. In this case, the interest rate
charged on the loan frequently resets to the market rate of interest, and therefore, the carrying
amount of the instrument is remeasured in accordance with HKFRS 9. The resulting carrying
amount will approximate fair value.
12.10.4 Nature and Extent of Risks Arising from Financial Instruments
Presenting financial instruments in the statement of financial position and statement of
comprehensive income provides some information about the nature of financial instruments
an entity is party to. However, more information is necessary to gain a deep understanding of
the significant risks associated with holding those instruments and how the entity manages
those risks. For this purpose, HKFRS 7 focuses on three core risks:
1. Credit risk;
2. Liquidity risk; and
HKFRS
7.32 3. Market risk.
HKFRS 7 requires qualitative and quantitative disclosures concerning the above risks and
any other risks an entity considers significant.
12.10.4.1 Qualitative Disclosures
For each type of risk arising from a financial instrument, an entity must disclose:
• The exposures to risk and how they arise;
• Its objectives, policies and processes for managing the risk and the methods used to
measure the risk; and
HKFRS
7.33 • Any changes in the above from the previous period.
12.10.4.2 Quantitative Disclosures
Credit risk disclosures are primarily concerned with financial assets measured at amortised cost
or at fair value through other comprehensive income (FVTOCI). In other words, if the impairment
HKFRS requirements of HKFRS 9 apply to the instrument then the entity will be required to include that
7.35A instrument in its credit risk disclosures. These disclosures are restricted to these assets because
the effect of any credit deterioration is not captured in the entity’s profit or loss. Therefore,
focusing on the profit or loss of the entity or just the statement of financial position does not
provide sufficient information for a user to understand the entity’s exposure to credit risk.
Quantitative disclosures about credit risk focus on the movements of the entity’s expected
credit loss provision. The disclosure requirements include:
HKFRS • A reconciliation of the expected credit loss provision, showing separately the changes in
7.35H Stages 1, 2 and 3 provisions;;
HKFRS
• Changes in the expected loss provision attributable to significant changes in the gross
7.35I carrying amounts of financial assets to which the provisions relate;;
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• The effect of modifications of financial assets on the carrying amount of those assets
HKFRS where the modification resulted in the asset moving from lifetime expected credit
7.35J losses to 12-month expected credit losses; and
HKFRS • Disclosure of the gross carrying amount of financial assets by credit risk grade and by
7.35M the stage of the impairment model the asset is allocated.
To help users understand the liquidity risk of the entity, HKFRS 7 requires a maturity
HKFRS analysis of future contractual cash flows for financial liabilities and how the entity manages the
7.39 liquidity risk arising from the financial liabilities it holds.
Finally, for market risk, HKFRS 7 requires an entity to disclose:
• A sensitivity analysis for each type of market risk to which the entity is exposed at the
end of the reporting period, showing how profit or loss and how 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
HKFRS • Changes from the previous reporting period in the methods and assumptions used and
7.40 the reasons for those changes.
Common market risk variables include:
• Interest rate risk, which is the risk that the fair value or future cash flows of a financial
instrument will fluctuate because of changes in market interest rates;
• Currency risk, which is the risk that the fair value or future cash flows of a financial
instrument will fluctuate because of changes in foreign exchange rates; and
• Other price risk, which is the risk that the fair value or future cash flows of a financial
instrument will fluctuate because of any variable other than interest rate risk or
currency risk.
12.10.5 Transfer of Financial Assets
When an entity transfers a financial asset that does not satisfy the requirements for
derecognition or the entity maintains some form of continuing involvement in that asset, the
entity will effectively be exposed to risks that users must understand (see Section 12.6). HKFRS
7 requires an entity to disclose information that enables users of its financial statements:
• To understand the relationship between transferred financial assets not derecognised
in their entirety and the associated liabilities; and
HKFRS
• To evaluate the nature of and risks associated with the entity’s continuing involvement
7.42B in derecognised financial assets.
When a financial asset is not derecognised in part or in its entirety, an entity must disclose:
• The nature of the transferred assets;
• The nature of the risks and rewards of ownership to which the entity is exposed;
• A description of the nature of the relationship between the transferred assets and the
associated liabilities, including restrictions arising from the transfer on the reporting
entity’s use of the transferred assets;
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• When the counterparty (counterparties) to the associated liabilities has (have) recourse
only to the transferred assets, a schedule that sets out the fair value of the transferred
assets, the fair value of the associated liabilities and the net position (the difference
between the fair value of the transferred assets and the associated liabilities);
• When the entity continues to recognise all of the transferred assets, the carrying
amounts of the transferred assets and the associated liabilities; and
• When the entity continues to recognise the assets to the extent of its continuing
involvement (see paragraphs 3.2.6(c)(ii) and 3.2.16 of HKFRS 9), the total carrying amount
HKFRS of the original assets before the transfer, the carrying amount of the assets that the entity
7.42D continues to recognise and the carrying amount of the associated liabilities.
Where an entity can derecognise the financial asset in its entirety but has continuing
involvement in them, the entity must disclose at each reporting date:
• The carrying amount of the assets and liabilities recognised in the entity’s statement of
financial position and represent the entity’s continuing involvement in the derecognised
financial assets;
• The line items in which the carrying amount of those assets and liabilities are recognised;
• The fair value of the assets and liabilities that represent the entity’s continuing
involvement in the derecognised financial assets;
• The amount that best represents the entity’s maximum exposure to loss from its
continuing involvement in the derecognised financial assets, and information showing
how the maximum exposure to loss is determined;
• The undiscounted cash outflows that would or may be required to repurchase
derecognised financial assets (e.g. the strike price in an option agreement) or other
amounts payable to the transferee in respect of the transferred assets. If the cash
outflow is variable, then the amount disclosed should be based on the conditions that
exist at each reporting date;
• A maturity analysis of the undiscounted cash outflows that would or may be required
to repurchase the derecognised financial assets or other amounts payable to the
transferee in respect of the transferred assets, showing the remaining contractual
maturities of the entity’s continuing involvement; and
KFRS • Qualitative information that explains and supports the quantitative disclosures
7.42E required above.
Furthermore, for each type of continuing involvement, an entity must disclose:
• The gain or loss recognised at the date of transfer of the assets;
• The income and expenses recognised, in the reporting period and cumulatively, from
the entity’s continuing involvement in the derecognised financial assets (e.g. fair value
changes in derivative instruments);
• If the total amount of proceeds from transfer activity (that qualifies for derecognition)
in a reporting period is unevenly distributed throughout the reporting period (e.g. if a
substantial proportion of the total amount of transfer activity takes place in the closing
days of a reporting period);
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°° When the greatest transfer activity took place within that reporting period (e.g. the
last five days before the end of the reporting period); and
°° The amount (e.g. related gains or losses) recognised from transfer activity in that
part of the reporting period, and
HKFRS
7.42G
°° The total amount of proceeds from transfer activity in that part of the reporting period.
No specific disclosures are required for financial assets transferred in their entirety where
the entity has no further continuing involvement with the transferred assets.
Illustrative Example 17
Belvue Electronics (Belvue) decides to securitise HK$100 million of receivables it holds
from aircraft manufacturers. As part of the securitisation, Belvue sells an equitable
interest in the receivables to a special purpose vehicle, which issues notes to outside
investors to fund the acquisition. Because the creditworthiness of the manufacturers
is rated highly, Belvue agrees to pay installments to the special purpose vehicle even
if it has not collected the associated payment from the manufacturer. However, in
the event of default, the note holders only have recourse to the receivables from the
manufacturers and not all of Belvue’s assets. This is seen as a credit enhancement, and
therefore, Belvue can negotiate a lower financing fee for the transaction. However, this
credit enhancement means Belvue is unable to derecognise the receivables. At the end
of the reporting period, Belvue makes the following disclosure.
During the reporting period, the Group securitised a portion of receivables to fund working
capital for a major order received. The Group is unable to sell, pledge, or otherwise dispose
of the receivables but is liable to remit cash flows to investors even if their associated cash
flows are not received from the Group’s debtors. In the event of default, investors have limited
recourse to the debtors and not to the Group as a whole.
The table below sets out a schedule of the transferred assets, their associated liabilities and the
net exposure of the Group. Given the nature of the receivables and associated liabilities, the
carrying amounts below are a reasonable approximation of their fair values.
Financial assets measured at
amortised cost (HK$m)
Carrying amount of assets 100
Carrying amount of associated liabilities (100)
Net position –
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1 2 . 1 1 CURRENT DEVELOPMENTS
The IASB is currently performing a normal post implementation review (PIR) of the classification
and measurement provisions of IFRS 9. The IASB has also signalled that it plans for PIRs to be
conducted on the impairment and hedging provisions of IFRS 9.
It is too early to judge what impacts that reviews might have.
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SUMMARY
• An entity must recognise a financial instrument once it becomes party to a contract that
requires the transfer of financial assets, financial liabilities or equity instruments to settle an
obligation.
• All financial instruments are initially measured at fair value, including transaction costs in the
case of financial instruments subsequently measured at amortised cost or fair value through
other comprehensive income (FVTOCI).
• Financial assets are subsequently measured depending on the cash flow characteristics of the
instrument and the entity’s business model for holding that instrument:
°° Where the cash flow characteristics of the asset solely represent payments of principal and
interest and the entity holds the asset to collect its contractual cash flows, the asset will be
measured at amortised cost; and
°° Where the cash flow characteristics of the asset solely represent payments of principal and
interest and the entity holds the asset both to collect its contractual cash flows and to sell,
the asset is measured at fair value with any changes in fair value being recognised in other
comprehensive income.
°° If the asset’s cash flows are not solely payments of principal and interest or the entity
intends to trade the asset, it will be measured at fair value through profit or loss (FVTPL).
• An entity must recognise a provision for expected credit losses for all financial assets
measured at amortised cost or FVTOCI (except equity instruments designated as measured
at FVTOCI).
°° All financial assets initially carry a provision equal to losses that will probably occur in the
next 12 months (Stage 1).
°° If a significant increase in credit risk is observed, the entity will increase the provision to
cover all losses that are probable over the lifetime of the financial asset (Stage 2).
°° If a financial asset becomes credit impaired, the entity will only recognise interest revenue
based on the net carrying amount of the financial asset (Stage 3).
°° A simplified version of this model is available for trade receivables and some other assets
where an entity need only recognise lifetime expected credit losses so that it need not track
the credit risk associated with those assets.
• Financial liabilities are subsequently measured at amortised cost subject to certain exclusions.
• All derivatives are measured at fair value through profit or loss, including any financial assets
or financial liabilities an entity designates in this measurement category at initial recognition
to minimise or eliminate an accounting mismatch.
• Financial instruments are derecognised when their associated cash flows expire, terminate, or
are transferred to another party.
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• Financial assets are only derecognised in their entirety if all risk and rewards incidental to
ownership of the financial asset are completely transferred to another party. In all other cases,
the financial asset may be partially or not derecognised. Any obligations the entity assumes as
part of the transfer are recognised as liabilities on the statement of financial position.
• HKFRS 7 requires disclosures to present information on risks attached to the financial
instruments an entity holds. In addition, HKFRS 7 requires disclosure of transfers of financial
assets that do not qualify for complete derecognition.
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MIND MAP
FINANCIAL ASSET FINANCIAL LIABILITY
Right to receive cash or another Obligation to pay cash or delivery a
financial asset financial asset to another entity
Equity instrument of another entity Must have symmetry Right to exchange financial assets and
Right to exchange financial assets and between to entitles to be financial liabilities with another entity
financial liabilities with another entity a financial instrument in a potentially unfavourable scenario
in a potentially favourable scenario Obligation to deliver a variable number
Potential to receive a variable number of the entity’s own equity instruments
of the entity’s own equity instruments in settlement of a fixed obligation
to settle a fixed receivable MEASUREMENT CLASSIFICATIONS
All financial assets must have Financial assets
an associated expected credit loss • Amortised cost
provision if measured at amortised • Fair value through other comprehensive
cost or fair value through other income
comprehensive income (except • Fair value through profit or loss
equity instruments measured Financial liabilities
at fair value through other • Amortised cost
comprehensive income) • Fair value through profit or loss
EXPECTED CREDIT LOSSES FINANCIAL RECOGNITION AND DERECOGNITION
INSTRUMENTS
Three-stage model (HKFRS 9) Financial assets and financial liabilities
• Stage 1: 12-month losses are recognised when the entity becomes
• Stage 2: Lifetime losses party to a contract
• Stage 3: Lifetime losses, interest revenue Financial liabilities are derecognised in
determined on net carrying amount part or in full when their obligations are
discharged, expire or are otherwise
cancelled
Financial assets are derecognised in part
or in full when their cash flows expire or
are transferred.
Transfers qualify for derecognition where
substantially all risks and rewards for the
part under consideration are transferred
to another party
Any assets or liabilities arising form
a transfer are recognised on the date
of transfer
Answers to Knowledge Check Questions
Question 1
Answer A is incorrect. An arrangement to pay another party based on the entity’s
share price is within scope of HKFRS 2 Shared-based Payment and, therefore, outside
the scope of the financial instruments standards. Though the obligation is contractual
and requires the entity to transfer cash to another party, HKFRS 2 specifies its own
recognition, measurement and disclosure requirements particular to cash-settled share-
based payments.
Answer B is incorrect. All lease obligations are within the scope of HKFRS 16 Leases and,
therefore, outside the scope of the financial instruments standards.
Answer C is correct. An obligation to purchase equity instruments of an entity at the
discretion of another party is often called a written put option. This type of instrument
will require the entity to deliver cash in exchange for equity instruments of another entity;
therefore it meets the definition of a financial liability and is within the scope of HKFRS 9.
Answer D is incorrect. The financial instruments standards only apply to contractual
obligations. A probable obligation is within the scope of HKAS 37 Provisions, Contingent
Liabilities and Contingent Assets.
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Question 2
Each of the three accounting standards has its own, albeit interrelated, focus. These three
standards are addressed in turn below.
1. HKAS 32 is primarily concerned with the definition of financial instruments,
their classification as financial assets, financial liabilities and equity instruments.
This involves additional guidance for more complicated instruments that might
contain more than one of these elements. Furthermore, HKAS 32 specifies the
requirements for the presentation of treasury shares, dividends, interest and gains
and losses. Finally, HKAS 32 prescribes the situations in which financial assets and
financial liabilities may be presented net of each other.
2. HKFRS 7 specifies the disclosure requirements to assist users in understanding
the nature and effect of financial instruments on an entity’s profit or loss, financial
position and cash flows.
3. HKFRS 9 prescribes the recognition and measurement requirements for financial
instruments.
Question 3
The three subsequent measurement classifications available for financial assets are:
1. Amortised cost;
2. Fair value through other comprehensive income; and
3. Fair value through profit or loss.
Question 4
Answer A is incorrect. This is because the bond is initially measured at HK$5.1 million at
the start of Year 1, being the fair value of the bond on initial recognition plus transaction
costs (such as the brokerage fee). In addition, in a fair value through other comprehensive
income (FVTOCI) measurement model, the carrying amount on the statement of financial
position is influenced by interest revenue calculated using the effective interest method,
which is not utilised in the fair value through profit or loss (FVTPL) measurement
requirements. Review Illustrative Example 3 in Section 12.3.2.2.
Answer B is incorrect. The increase of HK$70,000 is the fair value change from the end
of Year 1 of HK$4.95 million to the end of Year 2, where the fair value of the bond is
HK$5.02 million. In addition, in a FVTOCI measurement model the carrying amount on
the statement of financial position is influenced by interest revenue calculated using the
effective interest method, which is not utilised in the FVTPL measurement requirements.
Review Illustrative Example 3 in Section 12.3.2.2.
Answer C is incorrect. The HK$20,000 increase represents the difference in the fair
value of the bond from initial recognition to the end of Year 2. However, in a an FVTOCI
measurement model, the bond is initially measured at HK$5.1 million, being the fair value
of the bond on initial recognition plus transaction costs (such as the brokerage fee). In
addition, in an FVTOCI measurement model, the carrying amount on the statement of
financial position is influenced by interest revenue calculated using the effective interest
method, which is not utilised in the FVTPL measurement requirements. Review Illustrative
Example 3 in Section 12.3.2.2.
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Answer D is correct. The decrease of HK$117,422 is the fair value adjustment necessary
when the bonds are recorded at FVTOCI. In that measurement model, the carrying amount
on the statement of financial position is also influenced by interest revenue calculated
using the effective interest method, which is not utilised in the FVTPL measurement
requirements.
Question 5
Debit Credit
HK$m HK$m
Brokerage expense 100,000
Cash 100,000
(Recognition of transaction costs as an expense as incurred because the bonds are
measured at fair value through profit or loss)
Debit Credit
HK$m HK$m
Investment in US Treasury Bonds 5,000,000
Cash 5,000,000
(Initial recognition of US Treasury Bonds. The initial measurement of a financial
asset at fair value through profit or loss (FVTPL) does not include transaction costs.)
Debit Credit
HK$m HK$m
Fair value gains/losses 50,000
Investment in US Treasury Bonds 50,000
(Movement in bonds by the end of Year 1)
Debit Credit
HK$m HK$m
Investment in US Treasury Bonds 70,000
Fair value gains/losses 70,000
(Movement in bonds from end of Year 1 to end of Year 2)
Debit Credit
HK$m HK$m
Fair value gains/losses 20,000
Investment in US Treasury Bonds 20,000
(Movement in bonds from end of Year 2 to end of Year 3)
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Question 6
FVTOCI FVTPL
Statement of financial position 5,020,000 5,020,000
Fair value gain/(loss) 103,328 – OCI 70,000 – P&L
Interest revenue 116,672 –
From a statement of financial position perspective, fair value through other
comprehensive income (FVTOCI) and fair value through profit or loss (FVTPL) measurement
categories present the same carrying amount for the bonds. This is because the entity’s
business model for holding the bonds includes the potential for sale, and therefore, the
market value of the bonds is useful information to users of the financial statements.
On the other hand, FVTOCI and FVTPL produce different outcomes on the statement
of comprehensive income. In the first instance, FVTOCI uses the effective interest method
to calculate interest revenue on the financial asset. This is allowed because the entity’s
business model includes the intention to hold the bonds to collect contractual cash flows.
On the other hand, FVTPL does not permit recognising interest revenue using the effective
interest method because market price revaluations are more relevant information to users
due to the entity’s intention to hold the bonds for trading.
Finally, only the FVTOCI measurement category includes an adjustment to other
comprehensive income to revalue the bonds on the statement of financial position, which
is unnecessary under the FVTPL measurement requirements.
Question 7
When a financial asset is recognised initially, the expected credit loss (ECL) provision will
initially reflect only the losses associated with probable loss events occurring within the
next 12 months. When a loan migrates to Stage 2 due to a significant increase in credit
risk, the entity is required to increase its ECL provision to recognise expected losses
that associated with loss events that are probable over the life of the financial asset. So,
the carrying amount of the related financial assets will decrease. Migration to Stage 3
occurs when the loan experiences a credit impairment event. Given that the asset has
become impaired the probability of loss events occurring over the life of the loan increase
significantly, and therefore, the provision held against the loan also increases.
Question 8
The loan is classified into Stage 1 of the expected credit loss impairment model on initial
recognition because a significant increase in credit risk has not occurred and the loan is
not a purchased or originated credit impaired loan.
Question 9
The journal entries the bank will recognise during the first year of the loan are:
Debit Credit
HK$m HK$m
Loan receivable at amortised cost 1,010,000
Cash 1,010,000
(Record the initial advance of funds)
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Debit Credit
HK$m HK$m
Impairment gains/losses (P&L) 5,000
Expected credit loss allowance 5,000
(Initial recognition of the ECL provision)
Debit Credit
HK$m HK$m
Cash 80,000
Loan receivable at amortised cost 5,140
Interest revenue 85,140
(Record cash received from borrower, interest revenue using EIM, accretion of loan
receivable for the amortisation of the upfront fee)
Question 10
The entity has agreed to sell assets for HK$1 million and has agreed to repurchase them
for a fixed future value. The entity is required to pay that fixed future value regardless
of the fair value of the assets it must reacquire. For example, the assets might have
experienced a significant increase in credit risk that might have considerably reduced their
fair value. Nevertheless, the entity cannot offer an amount less than the value determined
on the initial sale. Therefore, the entity is still exposed to the risks and rewards of
ownership of the assets and may not derecognise them.
Question 11
In this situation, the entity can take all market factors into account for the consideration
it offers to reacquire the assets. The entity that must sell the assets to the purchaser has
taken on the risk that the assets may no longer be worth their original acquisition cost.
Therefore, the entity has transferred significantly all risks and rewards of ownership of the
assets and may derecognise them.
Question 12
Loan modifications are treated as new loans where the difference between the present
value of the remaining cash flows of the original loan and the modified cash flows of the
renegotiated loan discounted at the original effective interest rate exceed 10%. However,
in this case, the entity has only renegotiated half its bank loan; therefore, the test applies
only to that portion. In this instance, the present value test is applied to the half of the loan
that is renegotiated, resulting in the derecognition of that half and the recognition of a new
loan based on the renegotiated terms and conditions.
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Question 13
The conversion option first becomes advantageous to the investor in Year 3.
Year Bonds Share price Value of shares Difference
HK$ HK$ HK$ HK$
0 100,000 3.0 30,000 (70,000)
1 100,000 4.5 45,000 (55,000)
2 100,000 6.8 68,000 (32,000)
3 100,000 10.2 102,000 2,000
4 100,000 15.3 153,000 53,000
Question 14
Considering the analysis performed to answer Question 13, the total return to the
bondholder behaves similarly to that of an ordinary share. The entity that issues the
instrument may be required to deliver a fixed number of its own equity instruments in
settlement of its fixed principal outstanding on the bonds. In this scenario, the case may
be that the economic outcome is merely the sale of the entity’s own equity instruments as
opposed to the settlement of debt.
Question 15
Debit Credit
HK$m HK$m
Cash 100,000
Bond 89,610
Equity 10,390
(Initial recognition of the compound instrument)
Debit Credit
HK$m HK$m
Interest expense 5,377
Bond 2,377
Cash 3,000
(Interest expense on bond using the effective interest rate of 6%)
Question 16
A derivative has:
• No or little initial upfront investment;
• A value derived from the value of another financial instrument; and
• A future settlement date.
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Question 17
In this case, Belvue is selling receivables denominated in its own functional currency (Hong
Kong Dollars) for consideration in the functional currency of the purchaser (Chinese Yuan).
The economic characteristics of the settlement required is aligned with the host contract
because Belvue will always be exposed to foreign currency volatility on transactions with
foreign entities that wish to settle in their own functional currency. The use of Chinese
Yuan is specific to one of the parties to the contract. This contrasts with the situation where
an entirely independent currency is used, in which case the economic characteristics of the
settlement option are not aligned with the parties to the contract. In this case, because the
economic characteristics are aligned, Belvue does not need to assess the remaining tests
for embedded derivatives because all three must be met for a derivative to be separated.
EXAM PRACTICE
QUESTION 1
Belvue Electronics (Belvue) and Hong Kong Commercial Bank (HKCB) are negotiating a new
funding arrangement that would see Belvue obtaining HK$25 million in cash to assist in
acquiring raw materials for a significant supply contract. Belvue would like to obtain this
funding through a mix of debt funding and selling its receivables.
Belvue decides to obtain the funding primarily through raising new debt, and therefore,
Belvue and HKCB negotiate a new loan facility on 1 January 20X4 for HK$20 million, paying
4.58% interest for four years. HKCB charges an establishment fee of HK$50,000 (resulting in
an effective interest rate of 4.65%).
To fund the remaining desired cash flow, HKCB agrees to purchase an equitable interest
in HK$5 million of receivables but requires Belvue to guarantee the first HK$1 million of
losses on those receivables. Keeping the asset transfer requirements in mind, Belvue
ensures that in all other cases, HKCB will have recourse only to the transferred assets and
not to Belvue’s other assets. As part of the arrangement, Belvue is required to pass on all
cash flows collected without material delay and is only obligated to remit cash it collects
on the receivables (subject to any losses on the assets that fall within the guaranteed
amount) and may not otherwise sell or pledge the receivables sold to the HKCB. An expected
credit loss provision of HK$50,000 is held against the receivables at the time of their sale.
Following the sale, an expected credit loss provision relating to the guaranteed receivables is
estimated to be HK$10,000.
On 1 January 20X6, Belvue realises it would be advantageous to extend the loan it
obtained for a further two years and obtain some additional funding for other use. On
that day, Belvue and HKCB renegotiate the loan to extend it for another two years with an
additional HK$5 million borrowed, and the interest rate for the entire facility being changed
to 4.62%, no fee was charged for this renegotiation. On this day, the present value of the
modified cash flows is HK$24,973,188.
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Required:
(a) Because this is a significant undertaking for Belvue, senior management is interested
in how the overall arrangement will be accounted for. As the financial controller,
your responsibility is to classify the loan into the appropriate HKFRS 9 measurement
category. You must do the following:
• Determine the classification for the new loan and justify your conclusion; and
• Prepare the journal entries necessary to account for the bank loan up to 31
December 20X5.
(b) The legal team has asked you to determine, as the financial controller to:
• Determine whether the transfer of the receivables to HKCB qualifies for
derecognition under HKFRS 9, either in part or in full; and
• Justify your determination for use in a memorandum to the Board. Given the target
audience, your justification must be limited to qualitative assessments.
(c) On 1 January 20X4 Belvue transfers the receivables to HKCB. Do the following:
• Explain the initial and subsequent measurement requirements that apply to the
HK$1 million guarantee Belvue provided to the bank for the transferred receivables;
• Prepare the journal entries as of 1 January 20X4 to record the transfer of the
receivables, including any journal entries necessary to account for the expected
credit loss provision; and
• Prepare the disclosure Belvue would make at the end of its reporting period on
31 December 20X4 to disclose the transferred assets and any associated liabilities
recognised.
(d) Prior to agreeing to the renegotiated loan terms on 1 January 20X6, Belvue’s legal
team would like your advice on how the modified loan would be accounted for. Do the
following:
• Explain whether the loan modification is considered a substantial modification
under HKFRS 9; and
• Prepare an illustrative journal entry that would be recorded on 1 January 20X6 to
account for the modification.
QUESTION 2
Belvue Electronics (Belvue) is keenly aware that companies must continue to evolve their
products offering to remain competitive and relevant in a globalised economy. However,
Belvue does not have the expertise, time or funds to invest in developing new products,
instead choosing to further refine its existing product lines. Belvue does not want to neglect
investing in new products though and, therefore, likes to make investments in start-up
companies that develop new and relevant technologies. Belvue intends to purchase
bonds issued by a start-up company creating radically new avionics software that will
substantially reduce aircraft fuel consumption. This investment is being considered within
Belvue’s venture capital fund that operates under the business model of holding assets
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to collect their contractual cash flows and for potential sale. The bonds have a face value
of HK$500,000, maturing in three years and paying an interest of 2% on the face value. In
addition, if the value of the start-up company increases by 50% in the next 12 months, the
company will start to increase the interest payment by an additional 0.2 percentage points
for each additional 5% increase in company value. By 30 June 20X8, the value of the start-up
has increased by 45% and is expected to go beyond 50% in a few months. However, by
31 December 20X8, one of the founders leaves the company, putting its future viability into
question, and by extension, the recoverability of the bond.
Required:
The venture capital division have sought your input into its due diligence for the new
investment. This due diligence is reviewed by Belvue’s board, and therefore, the team wants
to ensure all aspects of the investment are considered. In particular, the board has asked
you to advise on:
• The classification of the bond into the appropriate financial asset subsequent
measurement category; and
• An explanation of whether the expected credit loss impairment requirements apply
to these bonds
QUESTION 3
Belvue’s board has reviewed your advice on the bonds described in Question 2 and would
like to understand how the bonds would be accounted for under different circumstances. It
has provided a scenario where the bonds only pay 2% interest. In other words, there is no
modification to the cash flows on the bond for the value of the company. The 2% interest
charge only compensates Belvue for the time value of money and the credit risk of the
start-up company.
Required
The board has asked you to prepare a memorandum for it that considers the following:
• Whether the changed information results in a different subsequent measurement
classification, justifying your advice; and
• Whether the expected credit loss requirements apply under the new information
and comparing and contrasting the financial statement differences.
QUESTION 4
Belvue’s junior accountant has prepared the following disclosure for the upcoming annual
financial report:
Consolidated Note 20X7 20X6
HK$’000 HK$’000
Receivables (a) 4,700 4,200
Other financial assets (b) 31,050 29,980
Investments in debt and equity instruments (c) 2,120 2,901
Derivatives (d) 800 (150)
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(a) Receivables are amounts due from customers under short-term credit arrangements,
usually fewer than 30 days;
(b) Other financial assets represent longer-dated lines of credit to major customers that
engage in a significant amount of business with the company;
(c) Investments in debt instruments are ordinarily US Treasury Bonds for excess working
capital. Equity instruments include investments in entities that are not associates or
joint ventures; and
(d) Derivatives include foreign exchange forward contracts used in hedge accounting.
As Belvue’s financial controller, you must review this draft disclosure and specifically
provide the following feedback:
• To evaluate whether the disclosure adequately meets the objectives of
paragraph 8 of HKFRS 7; and
• To recommend improvements, if any, for the junior accountant to consider.
ANS W ERS T O E X AM P RACTICE
QUESTION 1
(a) The bank loan is classified as measured at amortised cost. HKFRS 9 requires all financial
liabilities to be measured in this manner unless it is a:
• Derivative;
• Liability arising on a partial transfer of a financial asset;
• Financial guarantee contract;
• Below-market loan commitment; or
• Contingent consideration within the scope of HKFRS 3 Business Combinations.
1 January 20X4
Debit Credit
HK$ HK$
Cash 19,950,000
Bank loan 19,950,000
(Initial recognition of the bank loan)
31 December 20X4
Debit Credit
HK$ HK$
Interest expense 927,675
Bank loan 11,675
Cash 916,000
(Interest expense for the year)
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31 December 20X5
Debit Credit
HK$ HK$
Interest expense 928,218
Bank loan 12,218
Cash 916,000
(Interest expense for the year)
(b) When considering the derecognition principles in HKFRS 9, it is important to analyse
each step of the derecognition process to minimise the risk of inappropriate
accounting. Each step is considered below:
1. Have the rights to the cash flows from the asset expired?
No, the cash flows have not expired as the receivables are yet to mature. Given the
cash flows will continue into the future, this test has not been passed and the next
must be considered.
2. Has the entity transferred its rights to receive the cash flows from the asset?
No, Belvue has undertaken an equitable assignment whereby it retains its rights to
collect cash flows agrees to pass those cash flows on to another entity.
3. Has the entity assumed an obligation to pay the cash flows from the asset?
Yes, Belvue has agreed to pay all cash flows it collects on the assets to another
entity without material delay and Belvue is prohibited from selling or pledging the
transferred assets. However, this test is only met for some of the cash flows. Belvue
has agreed to guarantee HK$1 million of the receivables, meaning the bank will
have a right to recourse to Belvue up to this amount. Therefore, Belvue fails the
derecognition criteria in respect of this HK$1 million. On the other hand, Belvue has
agreed to only remit cash flows it receives in respect of the remaining HK$4 million
and, therefore, may derecognise this portion of the receivables.
Belvue has transferred substantially all risks and rewards associated with only
HK$4 million of the receivables it has sold because it has guaranteed losses of up to
HK$1 million. This guarantee constitutes a continuing involvement in the transferred
asset and, therefore, disqualifies this portion of the receivable from derecognition.
(c) In this case, Belvue has a continuing involvement in the assets it has transferred to the
bank. HKFRS 9 requires an entity to measure that continuing involvement derecognise
the transferred financial assets to the extent of that continuing involvement.
Furthermore, HKFRS 9 requires that any liabilities arising on the partial transfer of
a financial asset also be recognised on transfer. Here, Belvue provided a financial
guarantee with respect to HK$1 million by agreeing to compensate the bank for any
losses it incurs on that portion of the loans. Conceptually, the bank has obtained
a right of refund from Belvue, so the bank still pays the HK$1 million but may call
those funds back in the event the transferred assets do not perform. Therefore, this
amount received is the premium paid for the guarantee. HKFRS 9 requires that the
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initial measurement of a financial guarantee contract be equal to the fair value of the
guarantee, which is ordinarily the premium received. This requirement is modified
in the instance of a transfer, where the initial measurement is the lower of the
guarantee amount or the asset transferred. Hence, the initial measurement is equal
to HK$1 million, being the lower of the guaranteed amount and the asset transferred
(HK$1 million also, in this instance). Subsequently, the guarantee will be measured
at the higher of the initial measurement or the expected credit loss allowance on the
associated financial assets.
1 January 20X4
Debit Credit
HK$ HK$
Cash 5,000,000
Receivables 4,000,000
Guarantee on transferred assets 1,000,000
(Transfer of receivables and associated credit guarantee)
Debit Credit
HK$ HK$
Expected credit loss allowance 45,000
Impairment gains/losses 45,000
(Reduce the ECL allowance to the estimate for the financial assets that
remain recognised)
Possible disclosure
During the reporting period, the Group transferred a portion of receivables to fund working
capital for a major order received. The Group is unable to sell, pledge or otherwise dispose of
the receivables and is only required to remit cash flows it receives on the transferred assets.
However, the Group provided a guarantee to absorb the first HK$1 million of losses on the
transferred assets. In the event of default, investors have limited recourse to the debtors and
not to the Group as a whole.
The table below sets out a schedule of the transferred assets, their associated liabilities and
the net exposure of the Group. Given the nature of the receivables and associated liabilities,
the carrying amounts below are a reasonable approximation of their fair values.
Financial assets measured
at amortised cost
(HK$m)
Carrying amount of assets 5
Carrying amount of associated liabilities (1)
Net position 4
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(d) Belvue must determine whether the modification is considered a substantial
modification. The table below shows the relevant information for this decision.
HK$
Opening balance of loan on 1 Jan 20X6 19,973,893
Present value of modified loan 24,973,188
Variance 4,999,295
The opening balance of the loan represents the present value of the remaining cash
flows on the bank loan discounted at the original effective interest rate. In comparison
to the present value of the modified cash flows discounted at the original effective
interest rate, the variance amounts to 25%. Therefore, the modification is considered
substantial because it exceeds the 10% limit prescribed by HKFRS 9. Accordingly, the
old loan must be derecognised through profit or loss with a new loan being recognised
similarly through profit or loss. On recognition of the new loan, Belvue would need to
calculate a new effective interest rate and amortise the loan accordingly. Belvue would
record the following journal entry on 1 January 20X6.
1 January 20X6
Debit Credit
HK$ HK$
Bank loan 19,973,893
Modification gains/losses 19,973,893
(Derecognise modified loan)
Debit Credit
HK$ HK$
Modification gains/losses 24,973,188
Bank loan 24,973,188
(Recognise new loan under modified terms and conditions)
QUESTION 2
At first glance, the interest paid on the bond does appears to be inconsistent with a basic
lending arrangement because it has the potential to vary based on the growth of the
start-up company. Given that all instruments that do not meet the solely payments of
principal and interest (SPPI) test must be classified as subsequently measured at fair value
through profit or loss, assessing the bond against this test first is most efficient.
A basic lending arrangement predominantly charges interest based on the time value
of money and the credit risk of the borrower. The interest rate can also include elements
for a profit margin and costs of the lender. In the case of the bond issued by the start-up
company, the time value is evident in the interest rate, but the interest rate can be modified
by the value of the start-up company. This variable is inconsistent with a basic lending
arrangement. Accordingly, the bond fails the SPPI test and is measured at fair value through
profit or loss irrespective of Belvue’s business model for managing that asset.
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Because the asset is measured at fair value through profit or loss (FVTPL), that fair
value measurement will incorporate the market’s expectations of the start-up company’s
credit risk. For this reason, HKFRS 9 does not require an entity to apply its impairment
requirements to FVTPL assets. Accordingly, the expected credit loss requirements will not
apply to the bond.
QUESTION 3
To: Board members of Belvue Electronics
From: Financial Controller
Date: dd/mm/yyyy
Subject: Start-up bonds paying 2% interest only
I refer to your query regarding an alternative scenario affecting the terms of a bond
issued by a start-up company.
In contrast to the terms and conditions of the growth-linked bonds issued by the
start-up company, the interest on the 2% interest-bearing bond is only compensating Belvue
for the time value of money and the start-up’s credit risk. These two variables are consistent
with a basic lending arrangement and meet the SPPI test. Therefore, considering Belvue’s
business model is necessary for managing the asset. As Belvue intends to hold the bonds to
collect contractual cash flows and for potential sale, the bonds would qualify to be classified
and subsequently measured at fair value through other comprehensive income.
The expected credit loss requirements of HKFRS 9 apply to financial instruments
measured at fair value through other comprehensive income.
Under both fact patterns, the statement of financial position will reflect the fair value of
the bond. However, because the 2% interest-bearing bond is classified at fair value through
other comprehensive income (rather than at fair value through profit or loss), an additional
expected credit loss provision will be recognised through other comprehensive income. The
effect on profit or loss under both fact patterns is similar, except for these impairment gains
or losses.
QUESTION 4
In reviewing the disclosure, you realise it is missing some key information that would assist
a user of the financial statements to understand the nature of the risks arising from Belvue’s
financial instruments. In particular, your feedback to the junior accountant in respect of
paragraph 8 of HKFRS 7 includes:
• That the disclosure does not indicate the measurement model being applied to any
of the financial instruments. Though deriving this for ‘Receivables’ and ‘Derivatives’ is
possible, it is unclear if it is possible for the other line items;
• That investments in debt instruments could comprise a mixture of instruments held
under a business model to collect their cash flows or to sell. The disclosure does not
provide the measurement model for these instruments, and therefore, a user cannot
discern the business model; and
• That aggregating investments in debt instruments and equity instruments is not
permitted as HKFRS 7 specifically requires an entity to separate these instruments.
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In your feedback to the junior accountant, you propose the following disclosure that
more accurately meets the requirements of paragraph 8 of HKFRS 7.
Consolidated Note 20X7 20X6
HK$’000 HK$’000
Receivables (a) 4,700 4,200
Other financial assets (b) 31,050 29,980
Investments in debt instruments (c) 1,560 2,401
Investments in equity instruments (d) 560 500
Derivatives (e) 800 (150)
(a) Receivables are amounts due from customers under short-term credit arrangements,
usually fewer than 30 days;
(b) Other financial assets represent longer-dated lines of credit to major customers that
engage in a significant amount of business with the company. These financial assets
are measured at amortised cost because the credit arrangements have market rates of
interest set at an arm’s length requiring regular repayments of principal and interest;
(c) Investments in debt instruments are ordinarily US Treasury Bonds for excess working
capital. The company may either hold these instruments to maturity or sell them prior
to maturity depending on the company’s working capital needs. Therefore, these
instruments are measured at fair value through other comprehensive income;
(d) Equity instruments include investments in entities that are not associates or joint
ventures. The company makes strategic investments in start-up companies that might
contribute significant advancements to the company’s product line. The company does
not intend to trade these equity investments and has therefore designated them as
subsequently measured at fair value through other comprehensive income; and
(e) Derivatives include foreign exchange forward contracts used in hedge accounting.
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13
Hedge Accounting
CHAPTER TOPIC LIST
13.1 Hedge Accounting 13.5.3 Hedges of a Net Investment
13.1.1 Scope in a Foreign Operation
13.1.2 Terminology 13.5.4 Rebalance of Hedging
13.5.5 Discontinuation of Hedge
13.2 Hedging Instruments
Accounting
13.2.1 Qualifying Instruments 13.5.6 Accounting for Costs
13.2.2 Designation of Hedging of Hedging
Instruments
13.6 Disclosure
13.3 Hedged Items
13.6.1 Risk Management Strategy
13.3.1 Qualifying Items 13.6.2 The Amount, Timing and
13.3.2 Designation of Hedged Items Uncertainty of Future
13.4 Qualifying Criteria for Hedge Cash Flows
Accounting 13.6.3 The Effects of Hedge
Accounting on Financial
13.5 Accounting for Qualifying
Hedging Relationships Position and Performance
13.5.1 Fair Value Hedge 13.7 Current Developments
13.5.2 Cash Flow Hedge
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LEARNING OUTCOMES
PRINCIPAL LO2: APPLY APPROPRIATE ACCOUNTING PRINCIPLES AND CONCEPTS TO ACCOUNT
FOR BUSINESS TRANSACTIONS
LO2.06: D
escribe and account for business transactions in accordance with Hong Kong Financial
Reporting Standards as they relate to: Hedge Accounting
13.01.01 Explain when a hedge relationship qualifies for hedge accounting
13.01.02 Identify fair value hedges, cash flow hedges and hedges for net investment
13.01.03 Account for fair value hedges, cash flow hedges and hedges for net investment
13.01.04 Prepare disclosure in respect of hedging
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OPENING CASE
BELVUE ELECTRONICS
B elvue Electronics (Belvue) was introduced in Chapter 12 and is an avionics manufacturer
for a number of major aircraft manufacturing customers. Given the global nature of the
aviation industry, Belvue is exposed to a number of foreign currencies and commodity prices
for the gold used in the circuitry of its avionics components.
In light of these risks, Belvue would like to establish a hedging strategy to meet the
requirements for hedge accounting under HKFRS 9. This will allow Belvue to hedge its
exposures to these risks while also being able to present the effect of that hedging on the
financial statements for Belvue’s shareholders and financiers.
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OVERVIEW
Entities may engage in various forms of hedging activity to mitigate risks relating to their
business exposures. They do this, if not too costly, by arranging counteracting exposures. For
example, an entity might have an obligation to pay US dollars (USD). To guard against that
exposure varying in the entity’s currency, the entity might enter into a derivative to obtain a
right to receive the needed units of USD at the appropriate time.
If an entity engages in hedging, it may also decide to apply hedge accounting. Adoption of
such accounting is voluntary but must, if adopted, be applied in accordance with HKFRS 9.
Hedge accounting provides exceptions from the requirements of other standards. Entities
need to assess whether those exceptions are attractive to them or not. Without applying hedge
accounting, all hedging instruments and hedged items would continue to be accounted for
separately as per the relevant accounting requirements in the applicable standards.
Hedge accounting is a way to account for matched exposures that accounting separately
for the hedged and hedging items, under conventional accounting standards, cannot achieve.
It does this by ensuring both items are measured on the same basis (fair value), with changes
in value being taken in the same place in financial statements (e.g. the profit or loss or other
comprehensive income) and, in certain cases, by allowing for differences in the timing of their
recognition.
Sometimes, the exposures of an entity provide a natural hedge where one aspect of
the business involves an exposure to certain risks and another to a mitigating exposure.
For example, an entity might have foreign operations that generate USD as their functional
currency even as the entity has borrowings denominated in USD. In such situations, hedge
accounting is not employed, and the reporting of the exposures follows normal accounting
requirements. Of course, management can explain how such natural hedges are working.
If an entity acquires derivatives to hedge certain exposures from an economic point of view,
it still might elect not to apply hedge accounting. In such a case, the entity would be accepting
any volatility in profit or loss arising from changes in the fair value of the hedging derivatives.
Hedging doesn’t eliminate risk; instead, it modifies the risk profile. Though hedging may
mitigate some chosen risks, it may mean forgoing benefits if the business exposure changes
favourably. For example, hedging against foreign currency risk for purchased raw materials to
achieve a planned margin for goods sold may see the entity forgoing the savings that would
occur if exchange rates changed favourably for its purchases.
This chapter sets out the requirements if hedge accounting is adopted, including how to
account for a fair value hedge, a cash flow hedge and a hedge of net investment in a foreign
operation.
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1 3 . 1 HEDGE ACCOUNTING
Hedge accounting, as specified in HKFRS 9, follows a relatively simple concept, which
is to account for a hedged item (an exposure of the entity) and a hedging instrument
(a countervailing exposure entered into by the entity) together and, in a similar way, to produce
an accounting outcome that reflects the economics of the hedge relationship.
HKFRS 9 sets down qualifying criteria that need to be met before hedge accounting can
be applied. Those criteria relate to which hedged and hedging items are eligible for hedge
accounting, the processes of designating and documenting hedges and the assessment of the
effectiveness of the hedging relationship.
This chapter introduces simple hedge relationships to illustrate how each form of hedge
accounting (fair value hedging, cash flow hedging and hedging of net investments in foreign
operations) works. Students are not expected to understand complex or exotic forms
of hedging.
Throughout this chapter, Exhibit 13.1 will be used to help you understand the content you
are studying.
Entity’s hedging activity
Hedge Hedge
Hedged item
relationship instrument
Qualifying
criteria
Hedge
accounting
Fair value Cash flow Net investment
hedge hedge hedge
EXHIBIT 13.1 Chapter navigation – overview
13.1.1 Scope
The scope of HKFRS 9 as it relates to hedge accounting is identical to that of financial
instruments more broadly, as discussed in Chapter 12.
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13.1.2 Terminology
Exhibit 13.1 provides an overview of the main terminology used in hedge accounting. The
terminology used in this chapter assumes you understand the key terminology referred to
in Chapter 12 as they are highly interlinked. HKFRS 9 introduces only terms specific to hedge
accounting. Instead, key concepts are explained in the main text of HKFRS 9 as well as in the
application guidance.
Designation means the process of identifying a relationship between a hedged item and a
qualifying (hedging) instrument for the purposes of applying hedge accounting.
Qualifying item means a recognised asset or liability, an unrecognised firm commitment, a
forecast transaction, or a net investment in a foreign operation, that can be hedged under the
requirements of HKFRS 9.
Key Learning Point
Hedge accounting is specified in HKFRS 9 and is, therefore, subject to the same scope
requirements as described in Chapter 12.
1 3 . 2 HEDGING INSTRUMENTS
Hedge accounting accounts, in a related way, for the offsetting exposures of the hedging
instruments and the hedged items.
Hedged items are sources of exposure to certain risks, which can lead to volatility in
the entity’s financial statements unless hedging instruments are in place (e.g. an unhedged
variable rate borrowing can expose the entity to changes in interest rates, and unhedged
purchases denominated in a foreign currency can give rise to varying purchase prices in local
currency terms).
Hedging instruments bring their own exposures to risk and volatility. Derivatives used as
hedging instruments are required to be measured at fair value (as standard setters consider
there is no other viable measure of a derivative). Changes in the fair value of derivatives can
bring volatility to the financial statements. This volatility is important because it will be used to
offset the volatility arising from a hedged item (see Section 13.3).
Keep the relationships between exposures in mind as that will help you understand the
requirements that HKFRS 9 places on which financial instruments can qualify as hedging
instruments.
Exhibit 13.2 shows the topic covered in this section. A hedging instrument is one
component of a hedge relationship. A hedge relationship refers to the hedged items and
hedging instruments matched together to achieve a reduction in exposure to particular risks
that cause volatility in the entity’s financial statements.
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Entity’s hedging activity
Hedge Hedge
Hedged item
relationship instrument
Qualifying
criteria
Hedge
accounting
Fair value Cash flow Net investment
hedge hedge hedge
EXHIBIT 13.2 Hedging instruments
Placing a hedged item or a hedging instrument in a hedge relationship is referred to as
designation, which is a formal process under HKFRS 9 and is important later when considering
the qualifying criteria for hedge accounting (see Section 13.4).
This section covers the qualifying criteria for a hedging instrument to be designated into a
hedge relationship. Likewise, Section 13.3 covers the same topics for hedged items.
Examples of common hedging instruments include:
• Interest rate swaps, in which two parties agree to exchange fixed interest cash flows
and variable interest cash flows. For example, a borrower exposed to a variable rate
may enter into a swap arrangement to pay fixed rates;
• Forward contracts, in which one party is required to sell or buy a financial instrument,
a non-financial asset (e.g. a commodity), or liability at a future date for a contractually
specified price;
• Cross-currency interest rate swaps, in which two parties agree to exchange
interest payments (similar to an interest rate swap) in two different currency
denominations; and
• Options, which permit the holder a choice but do not impose an obligation to act to
purchase or sell an item at a future date.
13.2.1 Qualifying Instruments
Hedged items and hedging instruments need to be able to be measured on a consistent basis
with each other to achieve consistent accounting for the offsetting exposures previously
discussed.
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A qualifying hedged item, as previously defined, means a recognised asset or liability,
an unrecognised firm commitment, a forecast transaction, or a net investment in a foreign
operation that can be hedged under the requirements of HKFRS 9. The hedged item could be
a single item, a group of items or a component of either. It must be reliably measurable, or it
must be highly probable if it is a forecast transaction.
HKFRS A financial instrument generally can qualify as a hedging instrument if it can subsequently
9.6.2.1–6.2.2 be measured at fair value through profit or loss (see Chapter 12). This is true of the majority of
non-derivative financial instruments, for example, instruments that an entity can designate on
initial recognition as being measured at ‘fair value through profit or loss’. It is also true of most
derivative financial instruments, which are to be subsequently measured at fair value.
Instruments that routinely qualify for as hedging instruments include:
• Interest rate swaps for which fair value movements are attributable to changes in
market interest rates;
• Forward contracts for which fair value movements are attributable to changes in the
market rates of the underlying item (e.g. commodities and foreign currency exchange
rates); and
• Non-derivative financial assets subsequently measured at fair value through profit or
loss (e.g. a long-term receivable) for which fair value movements are attributable to any
variable affecting the asset, such as interest rates, time value and credit risk.
As mentioned previously, to qualify as a hedging instrument the financial instrument must
be subsequently measured at fair value through profit or loss. When considering derivatives,
this means the derivative must be independently and separately measured at fair value
through profit or loss.
If a financial instrument contains an embedded derivative (see Chapter 12) that has not
HKFRS been separated from the host contract, that embedded derivative does not qualify as a hedging
9.B6.2.1 instrument.*
Consequently, throughout this chapter, when referring to derivatives as hedging
instruments, the derivative is either a stand-alone instrument or a separated embedded
derivative.*
There are exceptions to ‘all fair value through profit or loss financial instruments’ qualifying
as hedging instruments. Examples are:
• Written options, unless the written option is designated in a hedge relationship to offset
a purchased option and the combination of the two is not a net written option;
• The entity’s own equity instruments, which are neither financial assets nor financial
liabilities of the entity and, therefore, by definition cannot be hedging instruments;
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• Those financial liabilities designated to be subsequently measured at fair value through
profit or loss if the change in fair value attributable to credit risk on the liability is
recognised under HKFRS 9 in other comprehensive income; and
• Equity instruments (of other entities) subsequently measured at fair value through
other comprehensive income.*
The final qualifying criterion is that the financial instrument must be with a counterparty
HKFRS external to the reporting entity, for example, either the group for consolidated financial
9.6.2.3 statements or the individual entity for separate financial statements.
Hedge accounting may change where the fair value gains and losses arising from the
hedging instrument are recognised (either P&L or OCI). This change might have consequences
for where the tax effect attributable to the hedging instrument is recognised (refer to
Chapter 19).
The flowchart in Exhibit 13.3 summarises the preceding information.
Yes Does not qualify
Net written
Derivative
option?
No Qualifies
Financial Financial asset
Qualifies
instrument at FVTPL
Yes Does not qualify
Financial liability Own credit risk
at FVTPL through OCI?
No Qualifies
EXHIBIT 13.3 Qualifying hedging instruments
Illustrative Example 1
Belvue is committed to making a US$10 million payment in 12 months. To hedge the
foreign exchange risk (i.e. movements in the USD/HKD foreign exchange rate) created by
this transaction, it enters into a Foreign Exchange Contract (FEC) with a bank.
Under the terms of the FEC, Belvue fixes the exchange rate in HKD terms at which it
buys the US$10 million in 12 months. There is no upfront payment on entering into the
FEC, and the settlement will occur in 12 months. Hence the FEC insulates Belvue from
movements in the USD/HKD exchange rate over the next 12 months.
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Illustrative Example 1 (continued)
The table below includes an assessment of the FEC against the elements of the
derivative definition in HKFRS 9:
Derivative definition Application to FEC
a) Its value changes in response to the change in a The value of the FEC will be driven
specified interest rate, financial instrument price, by changes in the USD/HKD foreign
commodity price, foreign exchange rate, index exchange rate because the rate
of prices or rates, credit rating or credit index, or under the contract is fixed, meaning
other variable (the ‘underlying’); and the FEC can be either favourable or
unfavourable relative to prevailing
foreign exchange rates.
b) It requires no initial net investment or an initial Belvue does not pay anything
net investment that is smaller than what would be upfront to enter into the FEC.
required for other types of contracts that would be
expected to have a similar response to changes in
market factors; and
c) It is settled at a future date. The FEC will be settled in 12 months.
The FEC qualifies as a derivative under HKFRS 9. Furthermore, Belvue has not paid or
received any premium for it (i.e. it is not a written option), and the bank is a counterparty
external to Belvue. Therefore, the FEC qualifies as a hedging instrument under HKFRS 9.
13.2.2 Designation of Hedging Instruments
HKFRS If a financial instrument qualifies as a hedging instrument, it must generally be designated in
9.6.2.4 its entirety. This means that all movements in the fair value of the hedging instrument will
accounted for when assessing whether the hedge relationship still qualifies for hedge accounting
in the future (see Section 13.4) and how to account for the relationship (see Section 13.5).
In addition, this means the hedging instrument must be designated for its whole life (subject to
the qualifying criteria discussed in Section 13.4).
Hedging instruments are used to protect an entity from certain risks. However, a hedging
instrument rarely perfectly matches all risks associated with a hedged item. One of the risks
most common to hedging instruments that is rarely a major risk in a hedged item is that of a
change in the time value of money. For example, financial assets and liabilities subsequently
measured at amortised cost are not revalued for changes in the time value of money. In
contrast, a derivative does incorporate these changes in its fair value remeasurement. To
avoid causing ineffectiveness (see Section 13.5) resulting from changes in the time value of
money, HKFRS 9 permits an entity to remove those changes from some designated hedging
instruments, specifically:
HKFRS
9.6.2.4(a) • Changes in the time value of money component of the value of an option;
HKFRS • Changes in forward rates affecting the valuation of forward contracts such that only
9.6.2.4(b) movements in spot rates are hedged; and
HKFRS
9.6.2.4(b) • Changes in the currency basis spread of two currencies.
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All three of the preceding bullet points represent changes in the time value of money
or interest rate differentials for foreign exchange instruments to some degree. The exact
calculation and source of the preceding changes is the subject of other finance specialisations.
However, it is important to understand that in the context of hedge accounting, the volatility
that may arise from these factors can be removed from the hedge relationship. HKFRS 9
allows an entity to remove these variables from the hedge designation to minimise hedge
ineffectiveness (see Section 13.5.6).
Key Learning Point
Financial instruments are the sum of multiple variables. Some of these variables will
expose an entity to risks it might wish to hedge (or use to hedge other risks arising from
different assets or liabilities). Keep this view of financial instruments in mind when applying
hedge accounting.
Knowledge Check Questions
Question 1
Which two of the following financial instruments would qualify as a hedging instrument:
A A financial asset subsequently measured at amortised cost
B Forward foreign currency exchange contract
C A financial liability subsequently measured at amortised cost
D A financial asset subsequently measured at fair value through profit or loss
Question 2
Explain whether a written option would qualify as a hedging instrument.
Question 3
Identify the main feature that all qualifying hedging instruments share and explain why this
is important.
1 3 . 3 HEDGED ITEMS
Hedging instruments are designated into relationships to manage risks arising on hedged
items (see Exhibit 13.4). Though some significant restrictions exist on instruments that may be
hedging instruments, the requirements placed on hedged items are far less restrictive because
the purpose of hedge accounting is to account for the offsetting exposures that might arise
on financial instruments. Therefore, to severely restrict the items that could qualify would be
counterintuitive.
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While studying this section, keep in mind that hedge accounting under HKFRS 9 is designed
to be closely aligned with risk management, which is sometimes aligned with the way in which
other aspects of accounting are normally required or practised.
Exhibit 13.5 illustrates that this section covers hedged items, which is the other component
of a hedge relationship. Before applying hedge accounting to each component (being the
hedging instrument, the hedged item and the hedge relationship) are subject to strict qualifying
criteria to avoid accounting outcomes that are confusing and inconsistent with the purpose of
hedging from a risk management perspective.
Entity’s hedging activity
Hedge Hedge
Hedged item
relationship instrument
Qualifying
criteria
Hedge
accounting
Fair value Cash flow Net investment
hedge hedge hedge
EXHIBIT 13.4 Hedged items
13.3.1 Qualifying Items
HKFRS A hedged item can be any single or group of a recognised asset or liability, an unrecognised
9.6.3.1 firm commitment, a forecast transaction or a net investment in a foreign operation. Only
HKFRS qualifying items with a party external to the reporting entity may be designated into a hedge
9.6.3.5 relationship. As such, an entity cannot hedge an asset it owns, like property, plant and
equipment because no external parties are involved in owning such an asset.
Typical hedged items include:
• A variable rate debt that an entity wishes to change to a fixed rate exposure, thereby
attaining certainty of the entity’s interest cash outflows (see Exhibit 13.5);
• An unrecognised firm commitment, which is often a contract to purchase or sell
a non-financial item to satisfy the entity’s business needs (see Chapter 12 for the
‘own-use exception’). Variability might arise from the entity’s exposure to the prices of
the underlying items through changes in commodity prices and exchange rates;
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• A highly probable forecast transaction, which is similar to a firm commitment except
that the entity has not signed a contract, that is, the transaction is only ‘highly
probable’; and
• Transactions or assets and liabilities with cash flows denominated in foreign currencies,
where the entity would like to secure a fixed exchange rate to remove cash flow
volatility.
Variable rate
debt
(Pay variable
interest rate)
Synthetic fixed rate
debt
+ (Interest rate swap
converts the variable
rate debt into fixed
rate debt)
Interest rate
swap
(Pay fixed
interest rate,
receive variable
interest rate)
EXHIBIT 13.5 A typical hedged item: variable rate debt
HKFRS
9.6.3.3 HKFRS 9 allows an entity to hedge a highly probable forecast transaction. This is often
useful for anticipated future transactions that the entity has not yet committed to. For example,
a manufacturer knows it will most likely make sales denominated in a foreign currency
(i.e. USD) over the next six months. In this case, the manufacturer could enter into a number of
forward foreign currency contracts, which mature at the same time as the expected sales.
Hence, it fixes the foreign exchange rate at the foreign currency sales which are converted back
to HKD, that is, the foreign currency risk associated with the highly probable sales has been
hedged. See Illustrative Example 2.
HKFRS
9.6.3.2 The final qualifying criteria for hedged items is that they are reliably measurable. This
requirement is made explicit because an entity may hedge items ordinarily not recognised for
accounting purposes, for example, a highly probable forecast transaction and unrecognised
firm commitments. As such, those unrecognised items are not subject to the ordinary
scoping, recognition and measurement requirements of HKFRS 9. Therefore, the requirement
to be reliably measurable helps reduce the likelihood of inappropriate accounting for
exposures that, absent hedge accounting, would not qualify for recognition under any
accounting standard.
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Key Learning Point
Qualifying hedged items include a recognised asset or liability, an unrecognised firm
commitment and a highly probable forecast transaction provided the hedged item is
reliably measurable and is transacted with an external counterparty. Available facts like
a company’s historical sales and/or purchases could provide justification that a highly
probable forecast transaction meets the qualifying hedged item criteria.
Illustrative Example 2
Belvue enters into a purchase contract to acquire a specified amount of raw materials
in six months for use in its production requirements. The contract requires settlement
in US Dollars (USD) for the market price of the commodity on delivery. The contract to
purchase the raw materials qualifies as a hedged item because it is a firm commitment,
that is, a binding obligation.
Because the contract does not fix the foreign currency price of the raw materials,
Belvue would like to hedge this exposure. On the same day Belvue signs the purchase
contract, it enters into a foreign currency forward contract in which it purchases a fixed
amount of USD in exchange for a fixed amount of Hong Kong Dollars (HKD). Exhibit 13.6
illustrates hedging a firm commitment.
Firm
commitment
(FX risk as
commodity is
priced in a
foreign currency)
Exposure is hedged for
+ FX risk
FX forward
(removes FX risk)
EXHIBIT 13.6 Hedging a firm commitment
Separately, Belvue has an intention to purchase more raw materials quoted in a
foreign currency in the future (i.e. a forecast transaction with no contractual obligation).
Because it has a history of buying a certain quantity of raw materials to support its
manufacturing and sales requirements, it can hedge its intention to purchase the raw
materials. This is a highly probable transaction under HKFRS 9.
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13.3.2 Designation of Hedged Items
HKFRS Similar to hedging instruments, hedged items may be designated in their entirety or in
9.6.3.7 components. Components can be risk components (e.g. foreign exchange risk, commodity price
risk, interest rate risk), selected contractual cash flows (e.g. interest rate payments over the first
two years of a four year variable rate loan), or components of a nominal amount (e.g. US$50m
of a US$100m variable rate loan).
Unless a hedged item is exposed to a single risk, designating an entire asset or liability as
the hedged item is unusual. Far more common is the designation of a specific risk component,
such as interest rate risk, foreign currency risk or commodity price risk.
For example, a USD-denominated variable rate loan entered into by a Hong Kong company,
exposes the company to movements in US benchmark interest rate risk (i.e. Libor) and foreign
exchange risk (i.e. HKD/USD). In this case, the company could hedge the US benchmark interest
rate risk or the foreign exchange risk or could hedge both risks. Other examples can be seen in
Exhibit 13.7.
Hedged item Risk exposure
Variable rate HKD loan HK benchmark interest rates (e.g. Hibor)
Highly probable USD denominated sales HKD/USD exchange rate
Contract to purchase Brent Crude Oil (i.e. firm commitment) Brent crude oil prices in USD
EXHIBIT 13.7 Examples of hedged items and their financial risks
Taking this componentised approach ensures the hedge relationship remains demonstrably
effective, and the application of hedge accounting does not introduce unnecessary volatility
into an entity’s profit or loss or statement of financial position.
Apply and Analyse 1
Belvue requires gold for use in its avionics components to meet international aviation
safety standards. By international convention, gold is traded in US Dollars (USD). Belvue
enters into a contract for the purchase of gold at the spot exchange rate for USD in
six months.
Identify the risk components inherent in this contract.
Analysis
The contract specifies settlement against the price of gold quoted on the London Metals
Exchange (LME), which is in USD. Therefore, the risk components are:
• HKD/USD foreign exchange rate (for the USD required to buy the gold); and
• The price of gold as quoted on the LME, for example, US$1,200 per ounce.
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Knowledge Check Questions
Question 4
Identify which one of the following items that would not qualify as a hedged item:
A Financial liability subsequently measured at amortised cost
B A highly probable forecast transaction
C An interest rate swap that converts fixed interest cash flows into variable interest
cash flows
D An unrecognised firm commitment
Question 5
Which two of the following criteria are required to be met for a risk component to qualify
as a hedged item? The risk component must be:
A Observable in a highly liquid market
B Separately identifiable
C Reliably measurable
D Separable
Question 6
Describe a forecast transaction and the qualifying criteria for such a transaction to be
considered a hedged item.
1 3 . 4 QUALIFYING CRITERIA FOR HEDGE
ACCOUNTING
The combination of qualifying hedging instruments and hedged items is called a hedge
relationship. However, before the hedge relationship may be accounted for, it must meet a
number of qualifying criteria. Exhibits 13.8 and 13.9 illustrate that these qualifying criteria
appear to be the final step before hedge accounting may be applied. However, the reality is
that a hedge relationship must meet the qualifying criteria at inception and on an ongoing basis
for the duration of the hedge.
The qualifying criteria can be split into two groups: criteria that must be met at inception of
HKFRS the relationship and ongoing criteria. When establishing a hedge relationship, all the following
9.6.4.1 criteria must be met.
On an ongoing basis, the same qualifying criteria apply except for the preceding hedging
documentation requirement. The first two qualifying criteria, that is, eligible hedging
instruments and hedged items and formal designation and documentation, are straightforward
even for complicated hedging relationships. In reference to documentation, many hedge
accounting systems have developed templates that fill the relevant information automatically.
That information includes:
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• Identifying information about the hedging instruments and hedged items (e.g. trade
numbers, contract numbers);
• The nature of the risk being hedged; and
• How the entity plans to assess the hedge relationship for effectiveness (see Exhibit 13.10).
Entity’s hedging activity
Hedge Hedge
Hedged item
relationship instrument
Qualifying
criteria
Hedge
accounting
Fair value Cash flow Net investment
hedge hedge hedge
EXHIBIT 13.8 Qualifying criteria for hedge accounting
Hedge
accounting
chosen?
Hedged and If not, account
hedging separately for
items qualify? hedged and hedging
items per normal
standards
If yes, document
If yes,
objective and
designate hedge
strategy for hedge
Is hedge
effective?
If yes, apply
hedge
accounting
EXHIBIT 13.9 Qualifying criteria for hedge accounting
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The more complicated qualifying criteria is hedge effectiveness testing.
Credit risk
Economic
does not
relationship
dominate
Hedge ratio
matches
documentation
Effectiveness assessment
EXHIBIT 13.10 Hedging relationship
effectiveness requirements
HKFRS
The hedging instrument and the hedged item are economically related if their respective
9.B6.4.4 fair values generally move in opposite directions in response to the same hedged risk. This
does not necessarily mean the hedged item and the hedging instrument share the same
variable as long as the two variables are economically linked and generally move similarly in
response to the same market movement. A typical example is the Brent Crude Oil price and the
West Texas Intermediate (WTI) oil price, which are prices for crude oil (albeit different qualities).
Often, either of these prices will be used as benchmarks in more refined fuels, such as aviation
fuel. If a hedged item is based on Brent Crude Oil and the hedging instrument is based on WTI,
the relationship does not necessarily fail the economic relationship test. This is because the
price of Brent Crude Oil and WTI are still expected to move in the same general direction.
The effect of credit risk cannot dominate the fair value changes of the hedged item or the
HKFRS
9.B6.4.7 hedging instrument. This is because the credit risk associated with both items is often not
–B6.4.8 shared, and, therefore, cannot provide an effective offset for the related item. For example, an
entity might have a purchase order with Supplier A and a hedging derivative with Bank B. In the
case of the purchase order, the entity’s own credit risk is a factor in the fair value of the hedged
item (reflecting its ability to pay the supplier). On the other hand, Bank B’s credit risk is a factor
in the derivative. Neither party’s credit risk is economically linked to the other, and therefore, if
credit risk became the dominant factor in either fair value movement, the effect of hedge
accounting would be lost because the change in credit risk on one side would not be offset by
the change in credit risk on the other.
Finally, the hedge ratio must be considered. This is the ratio of the hedging instrument to
the hedged item, which need not be a one-to-one relationship. Common situations in which an
entity does not use a one-to-one relationship is where it uses exchange-traded derivatives (such
as futures or options) that have standardised notional amounts. For example, the Hong Kong
Stock Exchange (HKEx) allows market participants to trade listed Iron Ore futures contracts.
The contract size in these futures is 100 tonnes each. If an importer based in mainland China
wanted to hedge the acquisition of 150 tonnes of iron ore, it would need to use one derivative
or two derivatives to hedge its position. In each case, the hedge ratio would be 0.66 or 1.33,
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respectively. This hedge ratio needs to be documented in the hedge documentation and an
entity needs to ensure that it is maintained throughout the life of the hedge relationship, unless
rebalancing is required (see Section 13.5.4).
If a hedge relationship qualifies for hedge accounting, the entity must then decide whether
it will apply fair value hedge accounting, cash flow hedge accounting, or net investment hedging
if it is hedging its net investment in a foreign operation. These types of hedges are discussed in
the next section.
Illustrative Example 3
Belvue enters into a three-year variable rate HKD denominated loan with its bank. To
hedge against the interest rate risk (i.e. variable Hibor), it also enters into an interest
rate swap with the same bank to fix the variable interest rate it pays on the loan. Belvue
would like to apply hedge accounting per the requirements of HKFRS 9.
In determining the eligibility of the hedge, Belvue considered the following qualifying
criteria:
Criteria Analysis
Are there a valid hedged item and hedging Yes. The variable rate loan is a valid hedged
instrument? item. The interest rate swap qualifies as
a derivative and hence is a valid hedging
instrument.
Are there a formal designation and Yes. Belvue will put in place compliant hedge
documentation of the hedging relationship documentation detailing the hedge relationship,
including hedge ratio? including the hedge ratio.
Is there an economic relationship? Yes. The interest rate swap converts the variable
rate loan to a synthetic fixed rate loan.
Does credit risk dominate the fair value of No. The loan and interest rate swap are with
the hedging instrument or hedged item? investment grade counterparties.
Is the hedge relationship effective? Yes. The terms of the interest rate swap match
those of the variable rate debt, thus providing a
perfect hedge.
Knowledge Check Questions
Question 7
An entity would like to use a diesel fuel derivative instrument to hedge its exposure to
aviation fuel. Though the two fuels are derived from the same underlying product (oil),
their pricing does not often respond in the same way to changes in oil prices. Explain the
relevant criteria for considering whether the hedging instrument and hedged item are
economically related and identify whether this condition is met.
Question 8
Explain why the effect of credit risk is a key criterion that might prevent a hedge
relationship from meeting the qualifying criteria for hedge accounting.
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1 3 . 5 ACCOUNTING FOR QUALIFYING HEDGING
RELATIONSHIPS
The establishment of the relationship between the hedged item and the hedging item is a key
part of hedge accounting and can vary from straightforward to complicated (see Exhibit 13.11).
We focus here on the logic of establishing that relationship but do not explore the more
difficult situations.
Entity’s hedging activity
Hedge Hedge
Hedged item
relationship instrument
Qualifying
criteria
Hedge
accounting
Fair value Cash flow Net investment
hedge hedge hedge
EXHIBIT 13.11 Accounting for hedge relationships
This section covers the three hedge accounting treatments that HKFRS 9 provides. The
hedge accounting treatment applied depends on the nature of the risk an entity is hedging.
A cash flow hedge is generally used to minimise volatility in net profit; a fair value hedge is
generally used to minimise volatility in net assets. The journal entries shown in this section
for each of these types of hedges might appear confusing at first, but the objective of hedge
accounting is to offset the movement in a hedged item attributable to the hedged risk. All the
journal entries shown reflect the requirements in HKFRS 9 to achieve this and adhere to the
requirement to immediately recognise in the financial statements any ineffectiveness in the
hedge relationship.
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13.5.1 Fair Value Hedge
A fair value hedge protects the market value of the hedged item, that is, it eliminates the
volatility of market value changes in the hedged item.
Under a fair value hedge, the hedging instrument is subsequently measured at fair value
through profit or loss (which is the approach that would have been applied regardless of hedge
HKFRS accounting). Additionally, the carrying amount of the hedged item is adjusted for the fair value
9.6.5.8 movements of the hedged risk, which is also recognised in profit or loss. The only exception to
recognising these fair value changes in profit or loss is where an entity hedges an investment in
an equity instrument that is, through election, subsequently measured at fair value through
HKFRS other comprehensive income (see Chapter 12 and Exhibit 13.12). In this case, movements in the
9.6.5.8 fair value of the hedging instrument are recognised in other comprehensive income.
If the hedged item is a financial instrument subsequently measured at amortised cost, any
fair value adjustments recognised in the carrying amount of the financial instrument must be
amortised to profit or loss using an adjusted effective interest rate. (See Chapter 12 for a
discussion of the effective interest rate method.) This amortisation may begin any time after
HKFRS the hedge relationship commences but must begin no later than when the hedge relationship
9.6.5.10 ceases (see Section 13.5.5).
Hedging instrument Fair value gains and losses Profit or loss
Hedging item Fair valued for the Fair valued
Profit or
(initially recogniset hedged risk gains and
loss
at amortised cost) (e.g. interest rate risk) losses
In accordance
Fair value gains
with relevant
and losses
standard
EXHIBIT 13.12 Key features of fair value hedge accounting
Common fair value hedge relationships include:
• Converting a fixed rate financial instrument into a floating rate financial instrument
using an interest rate swap, perhaps because the entity can obtain better variable
interest rates due to changes in the market; and
• Converting a floating rate financial instrument from one benchmark rate (e.g. Prime) to
another (e.g. the Hong Kong Interbank Offer Rate) using an interest rate swap for risk
management purposes.
Common to all fair value hedges is that they do not eliminate cash flow volatility. Instead,
they create cash flow volatility or maintain it but referenced to a different variable.
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Illustrative Example 4
Belvue managed to obtain a four-year loan with a bank that required interest payments
at a fixed rate. Current market conditions led Belvue to believe that interest rates may
fall at some point during the tenure of its loan, thereby affecting the market value of its
loan. Accordingly, Belvue entered into an interest rate swap that converted the fixed rate
payment loan into a synthetic floating rate payment loan for the term of the loan. Belvue
decided to apply hedge accounting per the requirements of HKFRS 9.
Given the nature of the hedge relationship, the hedge qualified as a fair value hedge as
the fair value of interest payments are now tied to market movements. Under this
approach, the hedging instrument is subsequently measured at fair value through profit or
loss. The carrying amount of the hedged item (i.e. the fixed rate interest payment) is
HKFRS adjusted for the fair value movements of the hedged risk (i.e. interest rate risk), which is
9.6.5.8 also recognised in profit or loss.
If the terms of the interest rate swap match the fixed rate loan, then under the fair
value hedge model, the gain/loss amounts taken to profit or loss will offset each other
and the interest payments will reflect the market interest rates. In doing so, Belvue can
enjoy the benefits of a variable interest rate loan during a low interest rate market, and the
market value of its loan is at par. If Belvue had not entered into an interest rate swap, its
loan would have been overvalued as it would have paid excess interest.
Key Learning Point
A fair value hedge is aimed at protecting the market value of the hedged item. If the
hedged item is already subsequently measured at fair value through profit or loss,
an entity will often forgo applying fair value hedge accounting because the hedging
instrument and the proposed hedged item are already subsequently measured at fair
value through profit or loss. In respect of fair value hedge accounting, if the hedged item
and the hedging instrument are already measured at fair value through profit or loss, this
will often be referred to as a ‘natural hedge’. In such a case, fair value hedge accounting
saves the entity the effort of preparing hedge documentation and all related hedge
accounting disclosures.
Apply and Analyse 2
Belvue decided to invest its excess cash by purchasing a high-quality bond that pays fixed
rate income. However, Belvue believes that it could get a higher return from the market.
Belvue, therefore, entered into an interest rate swap with its bank, to convert the fixed
cash flows of the bond into floating cash flows. As a result of the interest rate swap, Belvue
has a synthetic floating rate bond, whose value will not change in response to movements
in the benchmark interest rate, that is, Hibor.
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Apply and Analyse 2 (continued)
Belvue chooses to apply hedge accounting per the requirements of HKFRS 9 for the
interest rate swap. Describe the type of hedge accounting it can apply for the hedge
relationship.
Analysis
The bond is initially recognised in the statement of financial position at amortised cost
(i.e. Belvue intends to hold the bond to maturity, and assuming it is held solely for
payments of principal and interest, the test for measurement at amortised cost is passed
in Belvue’s scenario).
The interest rate swap essentially converts the fixed rate bond into a floating rate bond
to protect the market value of the investment. Therefore, per the requirements of HKFRS 9,
the hedge meets the requirements of a fair value hedge. Under a fair value hedge model:
• The interest rate swap is fair valued through profit or loss; and
• The carrying value of the bond is adjusted for fair value of the interest rate risk
(i.e. the hedged risk)
To illustrate this, the table below contains some values, which we will utilise to post the
general ledger entries required to record the fair value hedge over two reporting periods.
Period Bond Fair value Total bond Fair valuea
(amortised adjustment (for carrying of interest
cost) interest rate risk) value rate swap
HK$’000 HK$’000 HK$’000 HK$’000
Inception $90 $0 $90 $0
End of period 1 $91 $10 $101 −$10
End of period 2 $92 $15 $107 −$15
a
For the purposes of this example we ignore credit risk and assume 100% matched terms.
At inception, the following journals would be posted to recognise the bond:
Debit Credit
HK$ HK$
Bond (asset) $90,000
Cash $90,000
(Recognise the cash payment made by Belvue for the bond it invested in)
No entries to recognise the interest rate swap as it has a fair value of zero on the
inception date.
At the end of period one, the following journals would be posted to recognise the
bond, interest rate swap and fair value hedge accounting applied.
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Apply and Analyse 2 (continued)
Debit Credit
HK$ HK$
Bond (asset) $1,000
Interest Revenue $1,000
(Recognise the change in the amortised cost of the bond due to interest receivable)
Debit Credit
HK$ HK$
Fair value gains/losses (profit or loss) $10,000
Derivative Liability $10,000
(Recognise the mark to market loss on the interest rate swap)
Debit Credit
HK$ HK$
Bond (asset) $10,000
Fair value gains/losses (profit or loss) $10,000
(Recognise the fair value gain as an adjustment to the bond carrying value to reflect
that it is in a fair value hedge relationship)
At the beginning of period two, the fair value hedge accounting journals posted at the
end of period one are reversed. So, only the journal recognising the amortised cost of the
bond remains.
At the end of period two the following journals would be posted to recognise the bond,
interest rate swap and fair value hedge accounting applied.
Debit Credit
HK$ HK$
Bond (asset) $1,000
Interest Revenue $1,000
(Recognise the change in the amortised cost of the bond due to interest receivable)
Debit Credit
HK$ HK$
Fair value gains/losses (profit or loss) $15,000
Derivative Liability $15,000
(Recognise the mark to market loss on the interest rate swap)
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Apply and Analyse 2 (continued)
Debit Credit
HK$ HK$
Bond (asset) $15,000
Fair value gains/losses (profit or loss) $15,000
(Recognise the fair value gain as an adjustment to the bond carrying value to reflect
that it is in a fair value hedge relationship)
In summary, once you post all the journals, you end up with the following result at the
end of the first and second periods:
Profit and loss
[HK$’000]
Debit/(Credit) Period 1 Period 2
Interest revenue (1) (1)
Fair value loss (interest rate swap) 10 15
Fair value gain (adjustment to bond) (10) (15)
Statement of financial position
[HK$’000]
Debit/(Credit) Period 1 Period 2
Cash (initial purchase of bond) (90) (90)
Bond 101 107
Derivative liability (10) (15)
Retained earnings (interest income) (1) (2)
As can be seen from the table above, the profit and loss is only impacted by the
interest revenue earned on the bond. The derivative fair value impact in profit and loss has
been offset by the fair value adjustment made to the bond.
13.5.2 Cash Flow Hedge
Cash flow hedges are slightly more complicated than fair value hedges because the hedged
item continues to be accounted for in accordance with its ‘subsequent measurement’
classification irrespective of hedge accounting. However, the fair value movements arising from
the hedging instrument are assessed to determine the extent to which they are recognised in
HKFRS
other comprehensive income (OCI) through a cash flow hedge reserve or profit or loss
9.6.5.11 (see Exhibit 13.13).
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In accordance
Hedged item Fair value gains and losses with relevant
standard
Fair value Cash flow
Effective
Hedging instrument gains and hedge reserve
portion
losses (via OCI)
Ineffective Fair value gains
Profit or loss
portion and losses
EXHIBIT 13.13 Key features of a cash flow hedge
If the hedged item is a forecast transaction to acquire a non-financial asset or assume a
non-financial liability (including any such forecast transaction that subsequently becomes a firm
commitment in a fair value hedge), the hedge adjustments accumulated in the cash flow hedge
HKFRS reserve will form part of the carrying amount of the non-financial asset or non-financial liability
9.6.5.11(d) at the conclusion of the hedge relationship (see Section 13.5.5). The accumulated cash flow
HKFRS hedge reserve is reclassified to profit or loss as the hedged item affects profit or loss in all
9.6.5.11(d) other cases.
Common examples of cash flow hedges include:
• Converting a variable rate loan into a fixed rate loan to obtain certainty concerning
future interest payments;
• Fixing the price of commodity purchases to reduce volatility; and
• Fixing a foreign exchange rate
Determining the component of the movement in the hedging instrument that qualifies as
the effective portion is often determined as part of the hedge effectiveness test.
Key Learning Point
A cash flow hedge must reduce cash flow volatility. If a cash flow hedge results in increased
cash flow volatility, the hedge relationship will not qualify for cash flow hedge accounting.
For example, an interest rate swap that converts fixed interest payments into variable
interest payments would not qualify for cash flow hedge accounting.
Illustrative Example 5
Belvue has a variable rate borrowing owed to Bank A based on HIBOR. Belvue would like
to hedge its variable interest rate payments by entering into a floating-for-fixed interest
rate swap based on HIBOR. Given the swap and borrowing are priced off HIBOR, there is
an economic relationship.
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Illustrative Example 5 (continued)
The hedge relationship qualifies as a cash flow hedge. For effectiveness assessment
purposes, Belvue would have to use a hypothetical derivative as a proxy for the borrowing
to compare the movement in the fair value between the hedged item and hedging
instrument.
Apply and Analyse 3
Similar to the preceding illustrative example, Belvue has a borrowing from Bank A for
HK$2 million based on a variable HIBOR. Belvue wishes to fix its interest rate payments
and enters into an interest rate swap.
Belvue decides to apply cash flow hedge accounting to this relationship. The following
diagram illustrates the cash flows associated with this hedge relationship.
Illustration of the interest rate hedge
Pay variable Receive variable
HIBOR HIBOR Interest
Borrowing Belvue
rate swap
Pay fixed 1.7%
Calculate and prepare the appropriate journal entries for the duration of the hedge
relationship.
Analysis
The hedge relationship qualifies as a cash flow hedge relationship because it reduces the
cash flow volatility Belvue would have experienced if it did not have the interest rate swap.
As with the fair value hedge ‘Apply and Analyse 2’, the first step in preparing the
necessary cash flow hedge accounting journal entries is to value the interest rate swap.
Then we would need to construct and value the hypothetical derivative.
The cumulative change in these two derivatives will be used for calculating hedge
effectiveness, which is one of the criteria needed to qualify for cash flow hedge accounting
under HKFRS 9. In this case, the hypothetical derivative equals the actual derivative to
demonstrate the mechanics of measuring hedge effectiveness and deriving the journal
entries (illustrated below), but in practice a 100% effective hedge is not always the case.
Period Hedging Hypothetical Effectiveness
instrument derivative test
HK$ HK$
0 – – N/A
1 $7,823.53 $7,823.53 100%
2 $983.77 $983.77 100%
3 – – 100%
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Apply and Analyse 3 (continued)
Finally, the table below shows the interest cash flows arising from the hedging
instrument (i.e. interest rate swap settlements) and the hedged item (interest rate
payments).
Interest payments and receipts
Period Interest Interest Interest Net interest
payment on payment on received on rate swap
loan swap swap settlement
HK$ HK$ HK$ HK$
1 35,800 34,000 35,800 1,800
2 39,200 34,000 39,200 5,200
3 44,000 34,000 44,000 10,000
This hedging relationship is recorded as follows:
End of period 1
Debit Credit
HK$ HK$
Cash flow hedge reserve (OCI) 7,823.53
Interest rate swap (liability) 7,823.53
(Recognise the FV movement in the hedging instrument, which is fully effective)
Debit Credit
HK$ HK$
Cash (asset) 1,800.00
Interest received (profit or loss) 1,800.00
(Net interest receipt on the interest rate swap)
Debit Credit
HK$ HK$
Interest expense (profit or loss) 35,800.00
Cash (asset) 35,800.00
(Interest expense on the loan)
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Apply and Analyse 3 (continued)
End of period 2
Debit Credit
HK$ HK$
Interest rate swap (liability) 6,839.77
Cash flow hedge reserve (OCI) 6,839.77
(Recognise the FV movement in the hedging instrument, which is fully effective)
Debit Credit
HK$ HK$
Cash (asset) 5,200.00
Interest received (profit or loss) 5,200.00
(Net interest receipt on the interest rate swap)
Debit Credit
HK$ HK$
Interest expense (profit or loss) 39,200.00
Cash (asset) 39,200.00
(Interest expense on the loan)
End of period 3
Debit Credit
HK$ HK$
Interest rate swap (liability) 983.77
Cash flow hedge reserve (OCI) 983.77
(Recognise FV movement on swap, clear cash flow hedge reserve; recognise hedge
ineffectiveness)
Debit Credit
HK$ HK$
Cash (asset) 10,000.00
Interest received (profit or loss) 10,000.00
(Net interest receipt on the interest rate swap)
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Apply and Analyse 3 (continued)
Debit Credit
HK$ HK$
Interest expense (profit or loss) 44,000.00
Cash (asset) 44,000.00
(Interest expense on the loan)
At the end of the hedge relationship, the cash flows associated with the interest rate
swap have expired, resulting in the instrument having a fair value of zero. Similarly, the
hedge relationship has completed, also resulting in the cash flow hedge reserve closing
with a nil balance. If neither of these balances equal zero at the end of a hedge relationship
where the hedging instrument has matured, the hedge accounting entries will have been
recorded incorrectly.
Apply and Analyse 4
Belvue expects to make a sale of US$15 million in 12 months-time. The sale does not have
any credit terms. A sales contract does not exist at this time but Belvue is fairly certain the
sale will occur based on historical records. As the sale is in US Dollars (USD), Belvue would
like to hedge the foreign currency risk.
Belvue does this by entering into a forward foreign exchange contract (FX forward,
where it fixes the amount of HKD that it will receive (i.e. it will receive HK$112.5 million for
converting US$15 million in 12 months). Hence, it will not be exposed to movements in the
HKD/USD exchange rate over the next 12 months.
Belvue would like to apply hedge accounting for the FX forward. The expected sale
qualifies as a highly probable transaction (i.e. valid hedged item). The FX forward is a
derivative and hence is a qualifying hedging instrument. Because the FX forward fixes the
amount of HKD Belvue would receive for the sale, it reduces the cash flow volatility, and
therefore, the hedge relationship qualifies as a cash flow hedge.
For illustrative purposes, we will assume that the forward and spot FX risks are the
designated risks, and we will ignore credit risk. We will utilise the values in the table below.
Month Hedging Hypothetical Effectiveness
instrument derivative test
HK$ HK$
0 – – N/A
1 $15,000 $15,000 100%
2 $75,000 $75,000 100%
12 – – 100%
Prepare the appropriate journal entries for the cash flow hedge.
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Apply and Analyse 4 (continued)
Analysis
The journals to book the cash flow hedge are as follows:
End of period 1
Debit Credit
HK$ HK$
FX Forward (Asset) $15,000
Cash flow hedge reserve (OCI) $15,000
(Recognise the FV movement in the hedging instrument, which is fully effective)
Because the sale is still highly probable, that is, not binding, it is not recognised in the
statement of financial position. Only when a sales contract has been issued, will the sale be
recognised.
End of period 2
Debit Credit
HK$ HK$
FX Forward (Asset) $60,000
Cash flow hedge reserve (OCI) $60,000
(Recognise the FV movement in the hedging instrument, which is fully effective)
For every period until settlement, the entire fair value of the FX forward will be
deferred to other comprehensive income (OCI), assuming the hedge remains a 100%
effective.
End of period 3
On maturity of the Foreign Exchange Contract (FEC), assuming the sale has taken place,
the fair value of the derivative will be zero as will the balance in the OCI account when
settlement occurs on maturity. Belvue will also book the cash settlement, that is, payment
of US$15 million and receipt of HK$112.5 million, in a separate journal not captured below.
The journal to remove the fair value recognised in OCI and the FX FEC is:
Debit Credit
HK$ HK$
Cash flow hedge reserve (OCI) $75,000
FX Forward (Asset) $75,000
(Recognise maturity of the FEC and the fact the settlement has occurred requiring the
reversal of the balance deferred in OCI)
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13.5.3 Hedges of a Net Investment in a Foreign Operation
HKFRS Hedges of a net investment in a foreign operation are accounted for similarly to cash flow
9.6.5.13 hedges. The difference is that the effective portion of the hedge relationship is recognised in
the foreign currency translation reserve instead of the cash flow hedge reserve (see
Exhibit 13.14). Furthermore, the amount accumulated in the foreign currency translation
reserve is reclassified from equity to profit or loss as a reclassification adjustment on disposal
HKFRS or partial disposal of the foreign operation as opposed to over the life of the hedge relationship
9.6.5.14 in a cash flow hedge. From this description, it can be seen that a net investment hedge is
limited to hedging foreign exchange risk arising from translating the net assets of the foreign
operation into the entity’s functional currency (see Chapter 31). Briefly, a foreign operation is an
entity that is a subsidiary, associate, joint arrangement or branch of a reporting entity, the
activities of which are based or conducted in a country or currency other than those of the
reporting entity. When hedging an entity’s exposure to a net interest in that foreign operation,
an entity can reduce the foreign currency translation risk recognised in profit or loss.
Foreign currency
Foreign exchange revaluation
Hedged item translation
differences
reserve
Fair value Foreign currency
Effective
Hedging instrument gains and translation
portion
losses reserve
Ineffective Fair value gains
Profit or loss
portion and losses
EXHIBIT 13.14 Key features of a net investment hedge
13.5.3.1 HK(IFRIC)-Int 16 Hedges of a Net Investment in Foreign Operation
When hedging a net investment in a foreign operation, understanding some key concepts
of accounting for exchange rates is important (see Chapter 31). Of most relevance here is
the functional currency of the parent entity and that of the foreign operation. The functional
currency of an entity is the currency of the primary economic environment in which the entity
operates. Determining this currency can be straightforward. For example, an entity based in
mainland China and earning revenue and incurring expenses in Chinese Yuan will have that
currency as its functional currency. Similarly, an entity based in Hong Kong would have as
its functional currency the Hong Kong Dollar (HKD) if the same facts applied. Nevertheless,
situations do arise where this assessment might not be straightforward, in which case further
consideration is necessary, as indicated in Chapter 31.
HK(IFRIC)-Int 16 clarifies that an entity may only hedge foreign exchange risk arising from
HK(IFRIC)-
the difference between the functional currency of the foreign operation and the functional
Int 16.10 currency of the parent entity. This clarification ensures that entities do not hedge foreign
currency differences arising from the presentation currency of the foreign operation.
The reason for this restriction is that an entity’s presentation currency does not give rise to
foreign exchange risk; it is merely the currency in which the entity’s financial statements are
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presented. In contrast, an entity’s functional currency is the dominant currency in which that
entity transacts. Therefore, a parent has a real foreign currency exposure to the functional
currency of a foreign operation’s net assets (see Exhibit 13.15).
Ultimate parent A
Hedges GBP 10m
Intermediate parent B
Hedges GBP 20m
Foreign operation
(GBP 30m net assets)
EXHIBIT 13.15 Intermediate
parent entity net
investment hedging
The final relevant clarification in the interpretation is that the hedging instrument that a
HK(IFRIC)- parent entity uses to hedge its net investment may reside anywhere in the group and need not
Int 16.14 necessarily be held directly by the entity applying net investment hedge accounting.
13.5.4 Rebalance of Hedging
Throughout the life of a hedge relationship an entity must continually assess the effectiveness
of that relationship. Minor amounts of ineffectiveness commonly arise because the hedging
instrument and the hedged item will have different counterparties, cash flow characteristics
and other market influences. However, when the hedging instrument and the hedged item are
not based on the same underlying economic variable, utilising different quantities of hedging
instrument and hedged item should maintain an effective hedge relationship.
Illustrative Example 6
An entity hedges a HK$100,000 borrowing based on Benchmark Rate A with a
hedging instrument that is based on Benchmark Rate B. The two benchmark rates
are economically related, and it is proven that Benchmark Rate B is consistently
1.2 × Benchmark Rate A. Therefore, the entity establishes a hedge ratio of 0.83 for this
1
relationship , meaning it will use a notional value of HK$83,000 for the hedging
1 .2
instrument to hedge the borrowing. Over a three-period time frame, the following
outcome arises.
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Illustrative Example 6 (continued)
Outcome of a hedge ratio
Period 1 Period 2 Period 3
Benchmark Rate A 2.00% 2.20% 2.10%
Notional (HK$) 100,000 100,000 100,000
Interest (HK$) (A) 2,000 2,200 2,100
Benchmark Rate B 2.40% 2.64% 2.52%
Notional (HK$) 83,000 83,000 83,000
Interest (HK$) (B) 1,992 2,191 2,091
Difference (HK$) (A) – (B) 8 9 9
Using a hedge ratio of 0.83, the entity can use the hedging instrument based on
Benchmark Rate B to hedge its exposure based on Benchmark Rate A, with only minor
ineffectiveness due to rounding of the hedge relationship to two decimal places.
HKFRS
9.6.5.5,
HKFRS
When ineffectiveness arises, an entity must determine the source of that ineffectiveness
9.B6.5.11 before it can consider the relationship for any rebalancing. Not all amounts of ineffectiveness
are necessarily due to a change in the relationship between the hedging instrument and the
hedged item as can be seen in the table above. However, if after performing an analysis of
hedge ineffectiveness, the entity determines that it is due to a change in the relationship
between the hedged item and the hedging instrument, the entity must rebalance the
HKFRS relationship if maintaining the current hedge ratio would produce an outcome that is
9.B6.5.13 inconsistent with hedge accounting. If a rebalancing is carried out, the entity must first
HKFRS recognise any ineffectiveness prior to rebalancing the hedge relationship and is accounted for
9.B6.5.8 as a continuation of the hedge relationship.
On rebalancing, the entity might adjust the volume of the hedging instrument or the
hedged item, but an entity cannot use a volume that does not exist. For example, if an
entity has a HK$100,000 borrowing as a hedged item it cannot change the volume of the
hedged item to an amount greater than the overall borrowing. This is similar for the hedging
instrument.
Illustrative Example 7
Similar to the previous Illustrative Example, an entity is hedging a total borrowing of
HK$100,000. At the start of the second period, the relationship between Benchmark Rate
A and Benchmark Rate B changes from 1.2x to 1.1x. The ideal hedge ratio is now 0.90
1
. The entity has already purchased a derivative based on a notional of HK$83,000, so
1.1
it decides to adjust the volume of the hedged item in the hedge relationship by solving
for x in the following equation.
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Illustrative Example 7 (continued)
83, 000
0.90
x
x 92, 222
The following table illustrates this change in the hedge ratio at the start of Period 3
(because the entity must recognise all ineffectiveness in Period 2 before changing the
hedge relationship).
Changed hedge ratio
Period 1 Period 2 Period 3
Economic Relationship 1.2 1.1 1.1
Hedge Ratio 0.83 0.83 0.90
Benchmark Rate A 2.00% 2.20% 2.10%
Notional (HK$) 100,000 100,000 92,222
Interest (HK$) (A) 2,000 2,200 1,937
Benchmark Rate B 2.40% 2.42% 2.31%
Notional (HK$) 83,000 83,000 83,000
Interest (HK$) (B) 1,992 2,008 1,917
Difference (HK$) (A) – (B) 8 192 20
In Period 2, when the economic relationship between Benchmark Rate A and
Benchmark Rate B changed, the difference between the interest payments under both
benchmark rates grew larger. This is because the hedge ratio became inappropriate. After
rebalancing in Period 3, the difference once again became negligible.
The reduced volume of the hedged item (being HK$7,778) is no longer part of the hedge
relationship and, therefore, is measured in accordance with the requirements of HKFRS 9
(see Chapter 12). The same would be true if the volume of the hedging instrument were
reduced. If the volume of the hedged item or the hedging instrument were increased, that
HKFRS
9.B6.5.16- increased volume would become part of the hedge relationship and accounted for in
B6.5.20 accordance with the type of hedge being applied.
13.5.5 Discontinuation of Hedge Accounting
HKFRS A hedge relationship must discontinue if it ceases to meet the qualifying criteria discussed in
9.6.5.6 Section 13.4 after taking into account any rebalancing (see Section 13.5.4). This includes
instances where the hedging instrument expires, is sold, terminated or exercised. However, if
an entity utilises a rolling series of hedging instruments, for example, by using short-term
interest rate swaps that are replaced as soon as they expire, such a rolling strategy is not the
discontinuation of the hedge relationship if that strategy is otherwise consistent with the
entity’s documented risk management objective.
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As an exception, if an entity is required by law (or the introduction of a law), which
has occurred in the past, to novate all its derivative positions through a central clearing
counterparty, that renovation will not be considered the expiration, termination, sale or
exercise of the original derivative. Instead, the entity assumes the new (centrally cleared)
derivative as the hedging instrument in the original hedge relationship. This exception is
limited to only those changes necessary for changing the counterparty name in the derivative.
Any other changes (such as interest rate, notional or maturity, e.g.) are likely to be viewed as
creating a new derivative as opposed to renovating the original derivative through a central
clearing counterparty.
HKFRS 9 specifies strict requirements to account for any amounts accumulated in a
separate component of equity for cash flow hedges and hedges of a net investment in a foreign
operation. These requirements were discussed in the preceding relevant sections. However,
they may be summarised as follows:
• Hedged items in a cash flow hedge that result in the recognition of a non-financial
asset or a non-financial liability – the separate component of equity is included in
the initial carrying amount of that non-financial item as an initial cost (if that amount
qualifies as such);
• All other cash flow hedges – the separate component of equity is recognised in profit
or loss on recognition of the hedged item in profit and loss, that is, balance is reversed
from OCI only when the hedge item impacts profit or loss; and
• For net investment hedges – the amount accumulated in a separate component of
equity is recognised in profit or loss only on disposal of the foreign operation
No special discontinuation requirements apply for fair value hedges because all fair value
changes have been recognised in profit or loss.
HKFRS An entity cannot voluntarily end a hedge relationship; it may only cease when the hedge
9.B6.5.22 relationship no longer qualifies for hedge accounting.
13.5.6 Accounting for Costs of Hedging
In some situations, the hedged item and hedging instrument may be priced off different
benchmarks, for example, hedge of jet fuel (hedged item) using West Texas Intermediate (WTI)
crude oil forward (hedging instrument). Hence, the fair value of a derivative is often affected by
variables that are absent from the hedged item, creating basis risk.
HKFRS 9 provides relief for the following types of basis risk:
• The time value of options; and
• Forward element of a forward contract (forward points).
As discussed in Section 13.2, an entity must designate the whole hedging instrument in a
HKFRS
hedge relationship, but it may remove the above items from the hedge relationship and
9.6.2.4 account for them using a ‘cost of hedging’ approach.
Time value and forward points are priced into the initial value of a derivative and move over
time. However, in all cases, these variables will tend towards zero as the instrument matures.
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In Exhibit 13.16, these pricing features have an initial value that fluctuates over time on a
decreasing trend to be nil at maturity of the instrument. The fluctuations around the trend line
have the possibility of contributing to hedge ineffectiveness if the underlying variable (currency
basis, e.g.) suddenly becomes significant. If the movement in that underlying variable is large
enough, the hedge might no longer be part of a qualifying hedge relationship even though the
movement in the actual hedged risk might otherwise still qualify.
EXHIBIT 13.16 Movements in costs of hedging
To avoid this outcome, an entity may designate only the change in the intrinsic value of an
option (thereby excluding its time value) or the spot element of a forward (thereby excluding
the forward points) from the hedge relationship.
13.5.6.1 Accounting for the Time Value of Options
If an entity designates only the change in the intrinsic value of an option as the hedging
HKFRS instrument, the entity must assess the nature of the hedged item to determine how to account
9.6.5.15 for changes in the time value of the option (the undesignated component). The nature of the
hedged item can be one of two types:
1. Transaction-related, where the time value of the option would qualify as a transaction
cost for the hedged item. For example, the acquisition of property, plant and equipment
in foreign currency hedged with a foreign currency option.
2. Time period-related, where the time value of the option is considered a cost of
obtaining protection from a risk for a period of time. For example, an interest rate
cap that would apply only if variable interest rates on a borrowing exceeded a
stated amount.
If the option is hedging a transaction-related hedged item, the fair value movements
associated with the time value of the option are recognised in a separate component of equity
HKFRS through other comprehensive income to the extent it relates to the hedged item (the critical
9.6.5.15(b) terms of the option match the hedged item). If the hedged item subsequently results in the
recognition of a non-financial asset or a non-financial liability or a firm commitment for such a
non-financial item for which fair value hedge accounting is applied, the amount accumulated in
the separate component of equity will become part of the initial carrying amount of that item.
Otherwise, the amount accumulated in a separate component of equity will be reclassified to
profit or loss.
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On the other hand, if the option is hedging a time period-related hedged item, the initial
HKFRS time value of the option is recognised in profit or loss on a systematic basis over the life of the
9.6.5.15(c) hedge relationship. This approach would amortise the initial time value in a manner
representing the trend line in Exhibit 13.16. All other movements in time value will be
recognised in a separate component of equity through other comprehensive income (OCI) to
the extent those movements relate to the hedged item. On completion of the hedge
relationship, all movements would have cancelled each other out and the separate component
of equity will be nil.
13.5.6.2 Accounting for the Forward Element of Forward Contracts of Financial
Instruments
When an entity excludes the forward element of a forward contract from the hedge
HKFRS relationship, it applies the same accounting to those components as for the time value
9.6.5.16 of options.
Key Learning Point
The cost of hedging approach is dependent on an entity being specific about the hedged
risk in the hedge relationship. If an entity includes the time value of money or forward
points in the designated hedged item, it will not be able to apply the cost of hedging
approach. The entity must exclude those items from the designated hedged risk to qualify
for the cost of hedging approach.
Apply and Analyse 5
It is important to understand the key features of a fair value hedge, cash flow hedge and a
net investment hedge. This will assist in matching hedged items with hedging instruments
to appropriately identify the type of hedge relationship those items may belong to. Assume
the entity has a HK$ functional currency.
Match the following hedging instruments and hedged items to their most appropriate
hedge relationship. Assume the relationships will meet hedge effectiveness requirements.
Hedging instrument Hedged item
Fixed to floating interest rate swap Firm commitment to purchase
inventory
US$ loan subsequently measured at fair Domestic loan paying a fixed 5%
value through profit or loss (including interest rate
changes in credit risk, which are not
recognised in OCI)
Commodity forward contract Net investment in a foreign operation
based in the United States
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Apply and Analyse 5 (continued)
Analysis
Fair value hedge
A fair value hedge introduces volatility into profit or loss to offset the volatility already
present from the hedging instrument. Therefore, first determine the hedged item and then
match an appropriate hedging instrument to that hedged item.
Two hedged items in the table do not currently produce volatility in profit or loss.
The first is the firm commitment, which is not currently recognised due to the ‘own-use
exception’ (see Chapter 12). The second is the domestic fixed-rate debt. A further analysis
of the available hedged items is necessary.
Of the hedging instruments listed, two currently produce volatility in profit or loss: the
USD debt and the fixed to floating interest rate swap subsequently measured at fair value
through profit or loss. These are each analysed against the two hedged items.
1. USD debt: this hedging instrument cannot hedge the firm commitment because
there is no economic relationship between the two. In other words, the fair value
movements on the debt will arise from foreign exchange rates and interest rate
changes in the United States. These changes have no relationship with changes in
the price of the inventory to be acquired. Furthermore, and for the same reason,
the USD debt cannot hedge the domestic debt because the fair value movements
of both debts will arise from interest rate movements in two different economies.
2. Fixed to floating interest rate swap: this hedging instrument cannot hedge the
purchase of inventory because there is no economic relationship between the
interest rate-driven fair value movements on the swap and the inventory purchase
price movements on the firm commitment. However, the interest rate swap is a
perfect match for the fixed rate domestic debt because an economic relationship
will exist.
Based on the analysis, the fair value hedge relationship will comprise the interest rate
swap as the hedging instrument and the domestic debt as the hedged item.
Cash flow hedge
A cash flow hedge can only reduce current (or potential) cash flow volatility to qualify
as a hedge relationship. Of the remaining two hedging instruments, only one hedging
instrument can do this: the commodity forward contract. This instrument cannot be used
to hedge a net investment in a foreign operation because there would be no economic
relationship. Therefore, the only viable option is for the forward contract to hedge the
firm commitment to purchase inventory. This will qualify because there is an economic
relationship between the forward contract and the firm commitment to purchase
inventory.
Net investment hedge
The remaining USD debt instruments as a hedging instrument and the hedged item being
a net investment in a foreign operation qualify for a net investment hedge. This is because
the foreign currency movements arising from the debt can be used to offset foreign
currency translation gains and losses arising from the net investment (see Chapter 31).
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Knowledge Check Questions
Question 9
An entity applies fair value hedge accounting to convert a fixed interest rate liability into
a variable interest rate liability. At the end of the current period, the movement in the fair
value of the hedging instrument (an asset) is an increase of HK$4,300. The carrying amount
of the financial liability is HK$120,000 and the movement in the fair value of the hedged
item is HK$3,900. Identify the correct journal entry to account for the hedged item and the
correct amount of hedge ineffectiveness:
A Dr Profit or loss: HK$3,900. Cr Financial liability: HK$3,900. Hedge ineffectiveness:
HK$400 gain.
B Dr Financial liability: HK$3,900. Cr Profit or loss: HK$3,900. Hedge ineffectiveness:
HK$400 loss.
C Dr Profit or loss: HK$4,300. Cr Financial liability: HK$4,300. Hedge ineffectiveness:
HK$400 gain.
D Dr Financial liability: HK$4,300. Cr Profit or loss: HK$4,300. Hedge ineffectiveness:
HK$400 loss.
Question 10
When the hedged item is a financial instrument subsequently measured at amortised
cost, under fair value hedge accounting, the financial instrument is remeasured for the fair
value movements of the hedged item. Describe the accounting requirements to be applied
to this fair value hedge adjustment.
Question 11
An entity applies cash flow hedge accounting to the commodity price risk of a highly
probable forecast transaction to purchase 50 kilograms of a commodity. The commodity
derivative is a futures contract for the purchase of the commodity in six months at a
fixed price of HK$45,000 per kilogram, which may be settled net in cash on maturity. At
the reporting date, the cumulative fair value movement of the highly probable forecast
transaction is HK$100,000 (an asset). In the previous period, the cumulative movement was
HK$120,000. Assume the hedge relationship is fully effective and prepare the necessary
journal entry in accordance with cash flow hedge accounting requirements.
Question 12
Assume the same fact pattern as in Question 11. On maturity the cumulative fair value
movement of the highly probable forecast transaction is HK$98,000 (still an asset), for
which the entity has recorded the relevant cash flow hedge accounting entries relevant to
the hedging instrument. The total purchase price paid for the commodity is HK$2,384,000.
Prepare the final journal entry necessary to account for the discontinuation of the cash
flow hedge.
Question 13
Compare and contrast the accounting requirements for net investment hedging with cash
flow hedging.
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1 3 . 6 DISCLOSURE
HKFRS 7 Financial Instruments: Disclosures specifies all disclosure requirements for hedge
accounting in paragraphs 21A to 24J. The disclosures broadly require a mix of qualitative
and quantitative disclosures to assist a user to understand the effect of hedge accounting on
an entity’s profit or loss and statement of financial position. Because hedge accounting has
a substantial impact on the recognition of gains and losses in either profit or loss or other
comprehensive income (OCI), users need the additional disclosure to fully understand the
nature of and risks associated with the entity’s financial instruments.
HKFRS Hedge accounting disclosures must be provided in a single note to the financial statements
7.21B or a separate section in its financial statements and provide information about:
• An entity’s risk management strategy and how it is applied to manage risk;
• How the entity’s hedging activities may affect the amount, timing and uncertainty of its
future cash flows; and
HKFRS • The effect that hedge accounting has had on the entity’s statement of financial position,
7.21A statement of comprehensive income and statement of changes in equity.
13.6.1 Risk Management Strategy
An entity must explain its risk management strategy for each risk category of risk exposures it
applies hedge accounting to. The aim of this disclosure is to help users understand how the
HKFRS respective risks arise, how the entity manages that risk and the extent of risk exposures the
7.22A entity manages.
The information disclosed should include:
• The hedging instruments used and how they are used to hedge risk exposures;
• How the entity determines the economic relationship between the hedged item and the
hedging instrument for the purposes of assessing hedge effectiveness; and
HKFRS • How the entity establishes the hedge ratio and what the sources of hedge
7.22B ineffectiveness are.
Where an entity does not designate an entire hedged item but only a component thereof in
a hedge relationship, it must also disclose:
• How the entity determined the risk component that is designated as the
hedged item; and
HKFRS
7.22C • How the risk component relates to the item in its entirety.
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Illustrative Example 8
Belvue uses commodity forward contracts and forward foreign exchange contracts (FX
forwards) to manage its exposure to their respective risks. With this information, Belvue
might disclose the following to satisfy the preceding disclosure requirements.
Belvue’s risk management strategy is to maintain product supply and sale margins
through the strict fixing of its exposures to commodity price risk and foreign currency
exchange risk. These risks arise on ordinary purchase and sale contracts with foreign
suppliers and customers. FX contracts and forward commodity contracts are used to hedge
these risks on a one-to-one hedge ratio. The hedging instruments are economically linked
to the hedged item through the matching of critical terms, primarily being the foreign
currency associated with the sale or purchase as well as the specific commodity where
relevant. These risk exposures are considered components of the overall hedged item and
are referenced with foreign exchange markets and domestic commodity exchanges.
13.6.2 The Amount, Timing and Uncertainty of Future Cash Flows
To assist users in understanding the amount, timing and uncertainty of future cash flows,
HKFRS HKFRS 7 requires an entity to disclose summary quantitative information about the terms and
7.23A conditions of hedging instruments. This information includes a profile (maturity analysis) of the
HKFRS timing of the nominal amount of the hedging instrument and, if applicable, the average price or
7.23B rate of the hedging instrument.
An entity is exempted from the preceding disclosures if it frequently resets hedging
relationships, such as when the hedged item or hedging instrument is frequently changed. In
HKFRS this case, HKFRS 7 requires additional disclosures to assist users in understanding how this
7.23C hedging approach meets the entity’s risk management strategy.
Finally, an entity must disclose all sources of hedge ineffectiveness, by risk categories, that
are expected to affect the hedge relationships the entity has designated. If any cash flow
hedges were applied to forecast future transactions in the previous period that are no longer
HKFRS expected to occur in the current period, the entity must also disclose a description of that
7.23D–23F forecast transaction that is no longer expected to occur.
13.6.3 The Effects of Hedge Accounting on Financial Position
and Performance
The final category of hedge accounting disclosures is primarily concerned with tabular data
allowing users to identify the components of the financial statements that are affected by
hedge accounting. The disclosures are extensive; however, an entity will need to apply
HKFRS judgement in determining the level of aggregation or disaggregation to apply, the level of detail
7.21C–21D necessary and the location of any additional explanation or emphasis where necessary. This
amount of judgement unfortunately results in disclosures that might not be comparable across
entities but instead may be specific to the entity’s hedging activities.
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In a tabular format, an entity shall disclose the following amounts related to items
designated as hedging instruments separately by risk category for each type of hedge (fair
value hedge, cash flow hedge or hedge of a net investment in a foreign operation):
• The carrying amount of the hedging instruments (financial assets separately from
financial liabilities);
• The line item in the statement of financial position that includes the hedging
instrument;
• The change in fair value of the hedging instrument used as the basis for recognising
hedge ineffectiveness for the period; and
HKFRS • The nominal amounts (including quantities, such as tonnes or cubic metres) of the
7.24A hedging instruments.
In a tabular format, an entity shall disclose the following amounts related to hedged items
separately by risk category for the types of hedges as follows:
• For fair value hedges:
°° The carrying amount of the hedged item recognised in the statement of financial
position (presenting assets separately from liabilities);
°° The accumulated amount of fair value hedge adjustments on the hedged item
included in the carrying amount of the hedged item recognised in the statement of
financial position (presenting assets separately from liabilities);
°° The line item in the statement of financial position that includes the hedged item;
°° The change in value of the hedged item used as the basis for recognising hedge
ineffectiveness for the period; and
°° The accumulated amount of fair value hedge adjustments remaining in the
statement of financial position for any hedged items no longer adjusted for hedging
gains and losses.
• For cash flow hedges and hedges of a net investment in a foreign operation:
°° The change in value of the hedged item used as the basis for recognising hedge
ineffectiveness for the period;
°° The balances in the cash flow hedge reserve and the foreign currency translation
reserve for continuing cash flow hedges and hedges of a net investment in a foreign
operation; and
°° The balances remaining in the cash flow hedge reserve and the foreign currency
HKFRS translation reserve from any hedging relationships for which hedge accounting is
7.24B no longer applied.
An entity shall disclose, in a tabular format, the following amounts separately by risk
category for the types of hedges as follows:
• For fair value hedges:
°° Hedge ineffectiveness; and
°° The line item in the statement of comprehensive income that includes the
recognised hedge ineffectiveness.
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• For cash flow hedges and hedges of a net investment in a foreign operation:
°° Hedging gains or losses of the reporting period recognised in other comprehensive
income (OCI);
°° Hedge ineffectiveness recognised in profit or loss;
°° The line item in the statement of comprehensive income that includes the
recognised hedge ineffectiveness;
°° The amount reclassified from the cash flow hedge reserve or the foreign currency
translation reserve into profit or loss as a reclassification adjustment (differentiating
between amounts for which hedge accounting had previously been used but
for which the hedged future cash flows are no longer expected to occur and
for amounts that have been transferred because the hedged item has affected
profit or loss);
°° The line item in the statement of comprehensive income that includes the
reclassification adjustment; and
HKFRS °° For hedges of net positions, the hedging gains or losses recognised in a separate
7.24C line item in the statement of comprehensive income.
Finally, when reconciling each component of equity in accordance with HKAS 1, HKFRS 7
HKFRS requires that any amounts recorded in OCI or reclassified from a separate component of equity
7.24E to profit or loss be easily distinguishable.
Knowledge Check Question
Question 14
Identify the key components of a disclosure concerning an entity’s risk management
strategy:
A The hedging instruments used and how they are used to hedge risk exposures
B How the entity determines the economic relationship between the hedged item and the
hedging instrument for the purposes of assessing hedge effectiveness
C The nature and timing of cash flows arising on the hedged item
D How the entity establishes the hedge ratio and what the sources of hedge
ineffectiveness are
1 3 . 7 CURRENT DEVELOPMENTS
From this chapter, it should be evident that hedge accounting under HKFRS 9 requires an entity
to establish a strong connection between the hedged item and the hedging instrument even
though HKFRS 9 does permit some group hedging, such as aggregated exposures, grouped
hedged items and net positions. The challenge for many risk managers is they often view their
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hedging activities as hedges of entire portfolios of exposures. These exposures could include
many offsetting positions beyond the restriction in HKFRS 9 to net positions of foreign currency
exposure. Finally, these portfolios of risk are dynamic, where exposures arise and expire
frequently. Furthermore, the hedging instruments used to hedge these portfolios similarly
change frequently.
Currently, HKFRS 9 does not permit the application of hedge accounting to this type
of economic net hedging activity. However, the IASB published a discussion paper in 2014
outlining potential approaches and has spent a considerable amount of time discussing
feedback on the discussion paper. During that time the Board developed and refined ‘core
areas’ that are central to an accounting model (core model) that might enable investors to
understand the effect of a company’s dynamic risk management.
In May 2022, the IASB added the Dynamic Risk Management project to its standard-setting
program and will discuss detailed proposals at forthcoming meetings. Any proposals arising
from the project are expected to have application limited to large financial institutions.
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SUMMARY
• Hedge accounting aims to present the financial statement effect of an entity’s hedging
activities in a manner that is understandable to users.
• Hedged items may be any recognised asset or liability, unrecognised firm commitments and
highly probable forecast transactions, with limited exclusions.
• A qualifying hedge relationship must meet the following criteria:
°° It must consist of only qualifying hedging instruments and qualifying hedged items;
°° The documentation of the hedge must exist on the day it is designated; and
°° The hedge relationship must continue to meet effectiveness requirements.
• Hedging instruments must be subsequently measured at fair value through profit or loss to
qualify as hedging instruments.
• Three types of hedge relationship are available:
1. F
air value hedge, where the hedging instrument continues to be subsequently measured at
fair value through profit or loss, and the hedged item is remeasured at fair value through
profit or loss for the hedged risk;
2. C
ash flow hedge, where the hedged item continues to be measured in accordance with
HKFRS 9, but the effective portion of the hedging instrument is recognised in other
comprehensive income; and
3. N
et investment hedge in a foreign operation, which is accounted for similarly to a cash
flow hedge.
• Hedge accounting must be discontinued when either the hedging instrument or the hedged
item cease to qualify for hedge accounting.
• The cost of hedging element of a hedging instrument (time value of an option, forward
element of a forward contract, foreign currency basis spread in a foreign currency swap) may
be accounted for separately to reduce the associated volatility from profit or loss.
• Disclosures include:
°° Describing an entity’s risk management strategy;
°° Providing quantitative data about the amount, timing and uncertainty of future cash flows
arising from hedging instruments; and
°° Providing quantitative data about the effect of hedge accounting on profit or loss and the
statement of financial position.
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MIND MAP
HEDGING INSTRUMENTS HEDGED ITEMS
Qualifying instruments - must be measured May be:
at fair value through profit and Loss • A recognised asset or liability
(all derivatives) • Highly probable forecast transaction
Designation of Hedging Instruments – • Unrecognised firm commitment
volatility that may arise from these factors Could be a component of the above if:
can be removed from the hedge relationship: • Separately identifiable
• Changes in the time value of money • Reliably measurable
• Interest rate differentials for foreign
exchange instruments FAIR VALUE HEDGES
QUALIFYING CRITERIA FOR HEDGE Hedged item is remeasured at fair value
ACCOUNTING through profit or loss for the hedged risk
Hedged adjustments are amortised via
Criteria that must be met at inception adjustment to effective interest rate of
of the relationship amortised cost instruments
Ongoing criteria If hedged item is a forecast transaction,
DISCLOSURE HEDGE accumulated fair value changes are
ACCOUNTING recognised as part of initial carrying
Risk Management Strategy (HKFRS 9) amount once unrecognised firm
The Amount, Timing and Uncertainty commitment occurs
of Future Cash Flows CASH FLOW AND NET INVESTMENT HEDGES
The Effects of Hedge Accounting on
Financial Position and Performance Hedged items continue to be measured in
accordance with the requirements of
HKFRS 9
Effective portion of fair value movements
in the hedging instrument are recognised
in a separate component of equity via
other comprehensive income
Ineffective portion is recognised in profit
or loss
For cash flow hedges:
• If hedged item results in the recognition
of a non-financial asset or a non-financial
liability, the amount accumulated in a
separate component of equity is included
in the initial carrying amount of that
non-financial item
• Otherwise, the amount accumulated in a
separate component of equity is reclassified
to profit or loss as the hedged item affects
profit or loss
For net-investment hedges–the amount
accumulated in a separate component of
equity is only reclassified to profit or loss
on disposal of the foreign operation
Answers to Knowledge Check Questions
Question 1
Answer A is incorrect. The hedging instrument must always be subsequently measured at
fair value through profit or loss in its entirety to qualify.
Answers B and D are correct. Both instruments are subsequently measured at fair value
through profit or loss, (b) being a derivative can only ever be measured as such (unless in a
cash flow hedge) and (d) being designated as such on initial recognition.
Answer C is incorrect. The hedging instrument must always be subsequently measured at
fair value through profit or loss in its entirety in order to qualify.
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Question 2
A written option may be a hedging instrument but only if it is designated as an offset to a
purchased option.
Question 3
All qualifying hedging instruments are subsequently measured at fair value through profit
or loss in their entirety. This is important because the aim of hedge accounting is to reduce
volatility in profit or loss arising from the hedged risk. If the hedging instrument is not
subsequently measured at fair value through profit or loss, it will be unable to reduce the
hedged risk.
Question 4
Answers A, B and D are incorrect. HKFRS 9 permits an entity to designate any recognised
asset or liability as well as unrecognised firm commitments and highly probable forecast
transactions as hedged items.
Answer C is correct. HKFRS 9 prohibits an entity from designating a derivative as a hedged
item (unless it is combined with a non-derivative exposure in an aggregated exposure
hedged item).
Question 5
Answer A is incorrect. A highly liquid market is not required. However, such a market would
assist in supporting a reliably measurable conclusion.
Answers B and C are correct. HKFRS 9 requires the risk component to be:
• Separately identifiable, such as being explicitly defined in a contract or being
implicit in the fair value movements of the risk component; and
• Reliably measurable, being that it may be calculated using a specific pricing formula
or using market inputs.
Answer D is incorrect. HKFRS 9 does not require a risk component to be separable from
the overall risk exposure. If this were a requirement, the application of hedging risk
components would be severely limited.
Question 6
A forecast transaction is one to which the entity is currently not committed but is
anticipated to occur in the future. A forecast transaction may qualify as a hedged item if it
is highly probable and reliably measurable.
Question 7
The two additional qualifying criteria for hedge accounting are:
1. The hedge relationship comprising only qualifying hedged items and qualifying
hedging instruments; and
2. The hedge ratio of the actual hedged items to the actual hedging instruments being
consistent with the hedge documentation.
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Question 8
Credit risk is specific to the parties to the contract and not to the underlying hedged
exposure. While changes in credit risk are common, they lead to ineffectiveness because
their movements are not offset by movements in the hedged item. If the fair value
movements of the hedged item or the hedging instrument are dominated by movements
in credit risk, hedge ineffectiveness would become unacceptably large. This outcome is
inconsistent with the objective of hedge accounting.
Question 9
Answer A is correct. To fully account for the information, the entity would have recorded
the following journal entry. From this entry, it is also evident that a gain of 400 will remain
in the hedging gain/loss account in profit or loss.
Debit Credit
HK$ HK$
Hedging instrument 4,300
Hedging gain/loss 4,300
(Record the fair value increase of the hedging instrument)
Debit Credit
HK$ HK$
Hedging gain/loss 3,900
Financial liability 3,900
(Record the increase in the fair value of the hedged item for the change in the hedged risk)
Answers B, C and D are incorrect. They do not correctly measure the fair value movements
of the hedged item.
Question 10
The entity may begin amortising the hedge adjustment at any time from the
commencement of the hedge relationship but no later than when the hedge relationship is
discontinued. This amortisation is reflected in an adjustment to the effective interest rate
of the hedged financial instrument.
Question 11
Debit Credit
HK$ HK$
Cash flow hedge reserve (OCI) 20,000
Hedging instrument 20,000
(With a 100% effective hedge relationship, the entire fair value movement of the hedging
instrument, being the movement between the two periods, is recognised in OCI.)
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Question 12
Debit Credit
HK$ HK$
Cash flow hedge reserve (OCI) 98,000
Commodity inventory 98,000
(The hedged position is an asset, meaning the amount recorded in the cash flow hedge
reserve is a credit. On completion of hedge accounting, the amount accumulated in the
cash flow hedge reserve is recognised in the initial carrying amount of the hedged item.)
Question 13
The requirements for net investment hedging and cash flow hedging are identical in the
following respects:
• The separate component of equity is adjusted to the lower of (in absolute terms)
the cumulative fair value movements of the hedged item and the cumulative fair
value movements of the hedging instrument; and
• Any ineffectiveness in the hedge relationship must be recognised in profit or loss in
the period the ineffectiveness occurs.
In contrast to cash flow hedging, net investment hedging uses the foreign currency
translation reserve (as opposed to the cash flow hedge reserve). The amount accumulated
in the foreign currency translation reserve is reclassified to profit or loss only on disposal
of the foreign operation. In a cash flow hedge, the amount accumulated in the cash flow
hedge reserve might be transferred to profit or loss or to the initial carrying amount of the
hedged item, depending on the nature of that hedged item.
Question 14
A, B and D are correct. HKFRS 9 requires an entity to disclose these items so a user can
understand the types of risks an entity is exposed to, what the entity uses to hedge those
risks and where that strategy may not fully eliminate profit or loss volatility.
Answer C is incorrect. Though arguably a component of the disclosure about the economic
relationship between the hedging instrument and the hedged item, HKFRS 9 is not a
specific disclosure requirement.
EXAM PRACTICE
QUESTION 1
Belvue operates in a highly competitive environment and, therefore, seeks to manage its
profitability by ensuring all relevant exposures to inventory purchases and finished goods
sales maintain a specified minimum margin.
To achieve this, Belvue’s risk management strategy is to hedge any variable exposure to
foreign exchange risk. This allows Belvue to target a fixed margin between purchases and
sales. At the end of the current period, Belvue plans to purchase 1,500 tonnes of aluminium
in 24 months, based on a highly accurate estimate of raw material requirements from
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a supplier in mainland China. The negotiated arrangement will require Belvue to pay its
supplier Chinese Yuan 9.5 million on that day. No sales contract has been issued and
generally a contract is only issued one month before the expected purchase. Also, the
supplier requires immediate payment on delivery, that is, no credit terms exist.
Belvue’s Chief Financial Officer would like to hedge the preceding foreign exchange
(FX) exposures and apply hedge accounting in accordance with HKFRS 9. Accordingly,
the risk management division proposes to transact a forward foreign exchange contract
(FX forward), which will fix the amount of HKD Belvue will need to purchase the required
amount of Chinese Yuan in 24 months.
Belvue’s CFO plans to designate the forecast transaction and the FX forward into a cash
flow hedge.
Required:
Question 1(a)
Before Belvue can designate the hedging instruments into a hedge relationship, it must
first determine whether the hedging instruments and hedged items meet their respective
qualifying criteria in accordance with HKFRS 9. The CFO has asked you to prepare a
memorandum explaining whether the hedging instruments and the hedged items qualify as
such in accordance with HKFRS 9.
Question 1(b)
Assuming that the hedging instruments and hedged items qualify in accordance with
HKFRS 9, Belvue’s CFO next asks you to explain whether the proposed hedging relationship
is expected to meet the economic relationship hedge accounting qualifying criteria on a
qualitative basis.
QUESTION 2
After reviewing the advice you provided, Belvue’s Risk Management Committee (RMC)
approves the acquisition of the FX Forward Contract with the following key terms:
• Expiry in 24 months.
• On expiry, Belvue will pay HK$10 million to and receive Chinese Yuan 9.5 million
from the bank.
The following information has been provided by Belvue’s treasury team to be used when
estimating the impact the derivatives will have on Belvue’s financial statements.
The RMC approval includes the requirement that the forecast transaction and the FX
Forward are designated in a cash flow hedge. The hypothetical derivative for the cash flow
hedge is determined to be identical to the actual FX forward used, meaning the hedge is
expected to be perfectly effective.
Period 0 1 2 3
Value of commodity forward (HK$) 0 10,620 20,170 0
Required:
Belvue’s Board would like to estimate the impact of the cash flow hedge. Prepare the journal
entries required to account for the cash flow hedge.
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ANSWERS TO EXAM PRACTICE
QUESTION 1(a)
Your memorandum focuses on the aspects the CFO is most interested in, which is whether
the FX forward would qualify as a hedging instrument and the expected purchase of
aluminium would qualify as a hedged item in accordance with HKFRS 9. The forecast
transaction, as a hedged item, is highly probable because Belvue can predict its raw material
requirements with high accuracy up to 24-months into the future because of existing
product orders. As such, this transaction qualifies as a hedged item. The FX forward is a
derivative and qualifies as a hedging instrument.
The hedge relationship would qualify as cash flow hedge because the FX forward fixes
the expected aluminium purchase price in HKD and will reduce cash flow volatility.
QUESTION 1(b)
Your memorandum explains that the simplest qualitative assessment leads to an economic
relationship between the FX forward and the highly probable purchase of aluminum in
Chinese Yuan. This is because the FX forward swaps a fixed amount of HKD for Chinese
Yuan. All the other critical terms (e.g. expiry date, amount) match between the FX forward
and the highly probable aluminum purchase.
QUESTION 2
Below is the expected journals
Debit Credit
HK$ HK$
Period 1
FX forward contract (Asset) 10,620
Cash flow hedge reserve (OCI) 10,620
(Fair value movement of the FX forward that is highly effective with no hedge
ineffectiveness.)
Period 2
FX forward contract (Asset) 9,550
Cash flow hedge reserve (OCI) 9,550
(Fair value movement of the FX forward that is highly effective with no hedge
ineffectiveness.)
Period 3
Cash flow hedge reserve (OCI) 20,170
FX Forward Contract (Asset) 20,170
(Recognise the maturity of the FX forward and reversal of the fair value deferred to
OCI and removal of the FX Forward Contract (in an asset position) from the statement
of financial position.)
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14
Impairment of Assets
CHAPTER TOPIC LIST
14.1 Principal Issues 14.4 Recognising and Measuring an
14.1.1 Scope Impairment Loss
14.1.2 Terminology 14.4.1 A ssets Measured Using the
Cost Model
14.2 Identifying an Asset that May
Be Impaired 14.4.2 Assets Measured Using the
14.2.1 Internal Sources of Revaluation Model
Information 14.4.3 Risk of Impairment
14.2.2 External Sources of Arising Immediately upon
Information Revaluation
14.2.3 Practical Guidance 14.5 Cash-generating Units
14.2.4 Timing of Performing and Goodwill
Impairment Tests 14.5.1 Identifying the
Cash-generating Unit to
14.3 Measuring Recoverable
Amount Which an Asset Belongs
14.3.1 General Principles 14.5.2 Recoverable Amount and
14.3.2 Fair Value Less Costs Carrying Amount of a
of Disposal Cash-generating Unit
14.3.3 Value in Use 14.5.3 Recognition of
14.3.4 Specific Application Issues Impairment Loss for a
Cash-generating Unit
14.5.4 Corporate Assets
14.5.5 Goodwill Impairment
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14.6 Reversing an Impairment Loss 14.7 Disclosure of an Impairment
14.6.1 R eversing an Impairment 14.7.1 E
stimates Used to Measure
Loss Recoverable Amounts of
14.6.2 Reversing an Impairment Cash-generating Units
Loss for an Individual Containing Goodwill or
Asset (LO8) Intangible Assets with
14.6.3 Reversing an Impairment Indefinite Useful Lives
Loss for a Cash-generating 14.8 Current Developments
Unit
14.6.4 Reversing an Impairment
Loss for Goodwill
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LEARNING OUTCOMES
PRINCIPAL LO3: EVALUATE AND ADVISE ON APPROPRIATE ACCOUNTING PRINCIPLES TO ACCOUNT
FOR COMPLEX BUSINESS TRANSACTIONS
LO3.07: D
escribe and account for business transactions in accordance with Hong Kong Financial
Reporting Standards as they relate to: Impairment of Assets
3.07.01 Describe assets that are within the scope of impairment of assets
3.07.02 Describe an asset that may be impaired by reference to common external and internal
indicators
3.07.03 Describe the cash-generating unit that an asset belongs to
3.07.04 Explain when an impairment review should be performed
3.07.05 Calculate the recoverable amount with reference to value-in-use and fair value less costs
of disposal
3.07.06 Classify different levels of impairment test: assets vs cash-generating units or groups of
cash-generating units
3.07.07 Advise and calculate the impairment loss, including the loss relating to cash-generating units
3.07.08 Advise on the allocation of impairment loss and account for subsequent reversal
3.07.09 Prepare and appraise disclosure in respect of an impairment loss, including critical
judgements and estimates
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OPENING CASE
FRESHPAK LIMITED
F reshPak Limited (FreshPak) is a large packaging company specialising mainly in traditional
food packaging products (such as cardboard, glass and plastic packaging) and also has a
footwear division. In 20X1, FreshPak acquired a smaller listed packaging company, Aurora
Limited (Aurora). Aurora manufactures cardboard, glass and plastic packaging products
and has an innovative environmentally friendly packaging division (‘EcoPak’) to cater to food
manufacturing companies seeking environmentally friendly packaging materials. EcoPak has
a specialised research and development (R&D) centre that has developed and patented a
number of plant-based packaging options in commercial use by Aurora.
Goodwill was purchased in the acquisition of Aurora and forms part of the assets that
will need evaluating for potential impairment. In addition, following the acquisition of Aurora,
FreshPak needs to identify its cash-generating units for the purpose of testing for impairment
and, if an impairment is identified, to measure and allocate the amount of the impairment loss.
The EcoPak plant-based packaging patents have been classified as indefinite life intangible
assets in the EcoPak cash-generating unit. Therefore, FreshPak must apply the specific
requirements of HKAS 36 for indefinite life intangible assets.
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OVERVIEW
Accounting for impairment is one of the most commonly applied processes required of entities.
Many of an entity’s non-financial assets will need to be assessed for possible impairment and
possible reversals of impairment. This is because recoverable amounts can vary considerably
over the economic life of non-current non-financial assets and, because HKAS 36 Impairment
of Assets generally requires that, if an impaired asset’s recoverable amount increases above
its previously impaired value as a result of a change in estimates, the impairment loss will be
reversed to the extent of that increase. An entity’s assets may be particularly vulnerable to
impairment when an entity operates in a cyclical or disrupted business.
In the case of a business combination, the recognition of purchased goodwill creates a
particular risk of impairment. For example, in the Opening Case, FreshPak Limited (FreshPak)
paid a purchase price that includes goodwill for all the packaging assets of Aurora Limited
(Aurora). If market conditions become less favourable for packaging products (e.g. costs of raw
materials increase unexpectedly or demand for packaging products decreases), the packaging
assets would become particularly vulnerable to possible impairment.
Given the significant range of assets to which impairment testing applies and the need to
estimate uncertain future cash flows in impairment tests, the impairment process will often be
highly subjective and time consuming.
This chapter will cover the key components of the impairment process, including
understanding when an impairment review should be performed, the level at which an
impairment review should be conducted (including the concept of cash-generating units)
and guidance on how to perform an impairment review, how to identify when reversals of
impairment occur and the judgements needed in preparing disclosures about impairment.
1 4 . 1 PRINCIPAL ISSUES
This chapter addresses the accounting for impairment of assets as set out in HKAS 36
Impairment of Assets. The objective of HKAS 36 is to prescribe the procedures aimed at
ensuring assets are carried at no more than their recoverable amount. HKAS 36 prescribes
the recognition, measurement and disclosure requirements for impairments of assets and
reversals of such impairments.
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The principal issues in accounting for impairments of assets are:
• The identification of when to conduct impairment testing;
• The identification of the level of aggregation of assets at which impairment testing
should be performed;
• The measurement process for an asset’s recoverable amount;
• The identification of when to reverse an impairment loss; and
• Disclosures to make about impairment losses and reversals of impairment losses.
In this section, you will gain an understanding of the types of assets to which HKAS 36
applies and be introduced to some of the terminology relevant to applying the principles in
that HKFRS.
14.1.1 Scope
HKAS 36 does not apply to all assets. For example, a number of asset types have specific
HKAS subsequent measurement requirements in their respective standards. The assets within and
36.2 outside the scope of HKAS 36 are summarised in Exhibit 14.1.
In scope Out of scope
• Property, plant and equipment • Inventories (HKAS 2)
(HKAS 16) • Contract assets (HKFRS 15)
• Intangible assets (including • Deferred tax assets (HKAS 12)
goodwill) (HKAS 38)
• Assets arising from employee benefits (HKAS 19)
• Specified financial assets:
• Financial assets within the scope of HKFRS 9
investments in subsidiaries
(HKFRS 10), associates (HKAS 28) • Investment property measured at fair value (HKAS 40)
and joint ventures (HKFRS 11) • Biological assets measured at fair value less costs to sell
• Right-of-use (lease) assets other (HKAS 41)
than investment property rights • Insurance contract assets (HKFRS 17)
of use measured under the fair • Non-current assets classified as held for sale (HKFRS 5)
value model (HKFRS 16)
EXHIBIT 14.1 Scope of HKAS 36
The scope of HKAS 36 includes tangible and intangible assets carried at revalued amounts
(i.e. the fair value at the date of the revaluation less any subsequent accumulated depreciation
and subsequent accumulated impairment losses) in accordance with other HKFRSs, such as the
revaluation model in HKAS 16 Property, Plant and Equipment or HKAS 38 Intangible Assets.
14.1.2 Terminology
Many of the defined terms in HKAS 36 are common to other HKFRSs (for example, carrying
amount, depreciable amount, depreciation (amortisation) and useful life). However, some
HKAS 36 key defined terms are critical to understanding the key concepts of accounting for
impairment of assets.
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Key defined terms are as follows:
• Cash-generating unit: the smallest identifiable group of assets that generates cash
inflows largely independent of the cash inflows from other assets or groups of assets.
• Corporate assets: assets other than goodwill that contribute to the future cash flows of
the cash-generating unit under review and of other cash-generating units.
• Costs of disposal: incremental costs directly attributable to the disposal of an asset or
cash-generating unit, excluding finance costs and income tax expense.
• Impairment loss: the amount by which the carrying amount of an asset or a cash-
generating unit exceeds its recoverable amount.
• Recoverable amount: for an asset or a cash-generating unit, meaning the higher of its
fair value less costs of disposal and its value in use.
• Value in use: the present value of the future cash flows expected to be derived from an
asset or cash-generating unit.
Key Learning Point
The scope of HKAS 36 includes assets carried at revalued amounts (i.e. fair value at the
date of the revaluation less any subsequent accumulated depreciation and subsequent
accumulated impairment losses) in accordance with other HKFRSs, such as the revaluation
model in HKAS 16 or HKAS 38.
1 4 . 2 IDENTIFYING AN ASSET THAT MAY
BE IMPAIRED
An asset is impaired when its carrying amount exceeds its recoverable amount (i.e. the higher
of fair value less costs of disposal and value in use).
HKAS 36.8–17,
HKAS 36.18–57, HKAS 36 uses the term ‘asset’, but the requirements apply equally to an individual
HKAS 36.109–116 asset or a cash-generating unit. For the purposes of this chapter, Sections 14.2–14.4
focus on impairment testing of assets and Section 14.5 focuses on impairment testing of
cash-generating units.
The two-step process involved in identifying and recognising impairment losses is
summarised in Exhibit 14.2.
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STEP 1: ASSESS WHETHER THERE IS AN INDICATION THAT AN ASSET MIGHT BE IMPAIRED
In performing Step 1 at the end of each reporting period, have regard to:
INTERNAL SOURCES EXTERNAL SOURCES
For example: For example:
• The asset’s condition • Market indications of a decline
• Significant changes in internal in the asset’s value
operations • Significant adverse changes
• Declining economic to the entity’s environment
performance of the asset • Adverse changes in market rates
• Receipt of dividends from an • Adverse comparison with
investment market capitalisation
(See Exhibit 14.3) (See Exhibit 14.4)
STEP 2: IF AN INDICATION OF POTENTIAL IMPAIRMENT EXISTS,
ESTIMATE THE ASSET’S RECOVERABLE AMOUNT
If the asset’s recoverable amount is less than its carrying amount, the asset is impaired.
EXHIBIT 14.2 Two-step process for identifying and recognising
impairments
Although an impairment test is generally only required when there is an indication of
impairment, for certain types of assets, impairment testing must be undertaken every year.
These are:
• Indefinite life intangible assets,
• Intangible assets not yet available for use; and
• Goodwill.
HKAS
36.10 This is discussed further in Section 14.2.3.
HKAS Impairment indicators may be provided by internal sources or external sources of
36.9 information. These are discussed in more detail in Sections 14.2.1 and 14.2.2, respectively.
14.2.1 Internal Sources of Information
Internal sources of information which are to be considered in assessing whether there is any
HKAS indication that an asset may be impaired, include but are not limited to the following in
36.12 Exhibit 14.3.
However, the list above is not exhaustive and there may be other internal indications
that an asset or cash-generating unit might be impaired (for example, a loss of a significant
customers or limited supplies of key inputs).
14.2.2 External Sources of Information
HKAS External sources of information, considered in assessing whether any indication exists an asset
36.12 may be impaired, include but are not limited to the following in Exhibit 14.4.
The list above is not exhaustive and there may be other external indications that an asset
or cash-generating unit might be impaired.
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Condition of the
• Evidence is available of obsolescence or physical damage of an asset
asset
• Significant changes with an adverse effect on the entity have taken place or are expected to take place
in the near future which will impact the extent or manner in which, an asset is used or is expected to be
Significant internal
used. These could include the asset becoming idle, plans to discontinue or restructure the operation to
operation changes
which an asset belongs, plans to dispose of an asset before the previously expected date, and
reassessing the useful life of an asset as finite rather than indefinite.
• Cash flows for acquiring the asset, or subsequent cash needs for operating or maintaining it, that are
significantly higher than those originally budgeted;
Internal reporting • Actual net cash flows or operating profit or loss flowing from the asset that are significantly worse
indicates declining than those budgeted
economic • A significant decline in budgeted net cash flows or operating profit, or a significant increase in
performance budgeted loss, flowing from the asset
• Operating losses or net cash outflows for the asset, when current period amounts are aggregated
with budgeted amounts for the future
• In relation to an investment in a subsidiary, joint venture or associate, the investor recognises a dividend
Dividends received
from the investment and evidence is available that
from an investment
• The carrying amount of the investment in the separate financial statements exceeds the carrying amounts
in a subsidiary,
in the consolidated financial statements of the investee’s net assets, including associated goodwill; and
joint venture
• The dividend exceeds the total comprehensive income of the subsidiary, joint venture or associate in
or associate
the period the dividend is declared
EXHIBIT 14.3 Internal sources of information that indicate possible impairment
• Observable market indications (sale prices for similar assets in the market place) that the asset’s value
Observable market
has declined during the period significantly more than would be expected as a result of the passage
indications
of time or normal use
• Significant adverse changes have taken place during the period, or will take place in the near future, in
Significant external the technological, market, economic or legal environment in which the entity operates or in the market
adverse changes to which an asset is dedicated. Examples include: changes in legislation requiring additional costs to be
to the entity incurred, unfavourable foreign exchange rate fluctuations, new competitors entering the market and
changes to foreign trade agreements.
• Market interest rates or other market rates of return on investments have increased during the period,
Adverse changes
and those increases are likely to affect the discount rate used in calculating an asset’s value in use and
in market rates
decrease the asset’s recoverable amount materially
Comparison with
market • The carrying amount of the net assets of the entity is more than its market capitalisation.
capitalisation
EXHIBIT 14.4 External sources of information that are indications of possible impairment
14.2.3 Practical Guidance
HKAS 36 includes some practical guidance on when the recoverable amount of an asset
does not need to be estimated. These are scenarios where it is highly unlikely that a material
impairment would arise. Situations where this approach is applicable include:
• If previous recoverable amount calculations show that an asset’s recoverable amount is
significantly greater than its carrying amount and no events have occurred that would
reduce that difference; or
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• If previous impairment testing shows that an asset’s recoverable amount is not
HKAS sensitive to particular indications of possible impairment, then impairment testing will
36.15 not be required even if these indications occur during the reporting period.
Some indications of possible impairment of an asset can also indicate a need to review the
asset’s useful life, depreciation/amortisation method, or residual value. For example,
indications of possible impairment in HKAS 36 include evidence of asset obsolescence or
physical damage, plans to discontinue an operation to which an asset belongs and plans to
dispose of an asset before the previously expected date. Depending on the indications of
HKAS possible impairment, such reviews may be necessary even if no impairment loss is recognised
36.17 for the asset.
14.2.4 Timing of Performing Impairment Tests
HKAS 36 prescribes the timing of impairment testing for each of the three asset groups:
1. Tangible assets and intangible assets that are subject to depreciation/amortisation;
2. Indefinite life intangible assets and intangible assets not yet available for use; and
3. Goodwill.
The timing requirements for each of these categories is shown in Exhibit 14.5.
Assets within the scope
of HKAS 36
Intangible assets
Tangible assets and
with an indefinite
intangible assets Goodwill
useful life or not
with finite useful lives
yet available for use
Test for impairment
annually (at any time
Assessment at the during the year, Goodwill is tested for
end of each reporting providing it is at the impairment annually,
period if an indication same time each year regardless of whether
of possible impairment for that asset) and an indication of
exists whenever an indication impairment is present
of possible impairment
exists
EXHIBIT 14.5 Timing of performing impairment tests by asset type
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Key Learning Point
HKAS An entity is not required to make a formal estimate of an asset’s recoverable amount if no
36.8 indication of an impairment loss is present. However, unless a material impairment is
highly unlikely to arise, an entity will have to estimate annually the recoverable amount of:
• An intangible asset with an indefinite useful life;
• An intangible asset not yet available for use; and
• Goodwill acquired in a business combination.
Knowledge Check Question
Question 1
Identify in which of the following circumstances an entity would become required to
estimate an asset’s recoverable amount:
A An asset is temporarily idle during regular major maintenance
B An asset has a long remaining useful life, and short-term market interest rates have
increased without a corresponding increase in long-term market interest rates
C A significant decline occurred in budgeted net cash inflows from an asset with
a previously estimated recoverable amount that did not significantly exceed its
carrying amount
D A new competitor enters a market for services similar to those rendered by an intangible
asset of the entity with an indefinite useful life. Previous recoverable amount calculations
for the asset showed that its recoverable amount greatly exceeded its carrying amount
1 4 . 3 MEASURING RECOVERABLE AMOUNT
If it has been determined an asset is to be tested for impairment (because it is required
annually or because an indication of possible impairment has been identified), the next step
will be for the entity to assess the recoverable amount of the asset. Section 14.3.1 provides an
introduction to the general principles for measuring an asset’s recoverable amount, particularly
the implications of recoverable amount being composed of the higher of two measures.
Sections 14.3.2 and 14.3.3 discuss those two measures and how to determine their amounts.
14.3.1 General Principles
The recoverable amount of the asset is assessed by determining the benefits of either holding
the asset and using it (an entity-specific value) or by selling the asset (a market-based value).
Exhibit 14.6 explains these concepts in greater detail.
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Recoverable amount = higher of
Fair value less costs of
Value in use
disposal
Assumes the carrying
Assumes the carrying
amount will be
amount will be recovered
recovered principally
principally through sale
through continuing use
EXHIBIT 14.6 Determination of asset’s
recoverable amount
If either of an asset’s fair value less costs of disposal or its value in use exceeds the asset’s
carrying amount, the asset is not impaired and estimating the other component of recoverable
amount is unnecessary.
The recoverable amount of an asset is compared with the asset’s carrying amount; if it is
less than the asset’s carrying amount, an impairment loss will be identified.
To illustrate this, if an asset’s carrying amount was HK$550 million and its recoverable
amount is HK$1 billion, there is no impairment loss to recognise. However, if the recoverable
amount is HK$450 million, an impairment loss of HK$100 million will be recognised.
Using estimates, averages and computational short cuts are acceptable when they provide
HKAS reasonable approximations of detailed computations that would otherwise be used to
36.23 determine fair value less costs of disposal or value in use. For example, in estimating future
revenue growth in cash flow projections, it is acceptable to use a representative multi-period
average of the revenue where revenue amounts are cyclical.
14.3.2 Fair Value Less Costs of Disposal
Fair value less costs of disposal is one of the two limbs of an asset’s recoverable amount.
The requirements for measuring fair value are set out in HKFRS 13 Fair Value Measurement.
(see Chapter 4). Under those requirements, fair value less costs of disposal can be measured
even if there is no quoted price in an active market for an identical asset.
HKAS
Costs of disposal are incremental costs directly attributable to the disposal of an asset,
36.6 excluding finance costs and income tax expense. Costs of disposal could be the costs of selling,
retiring, or scrapping an asset, whichever is the most likely scenario. Examples of disposal costs
include legal costs, stamp duty and similar transaction taxes, costs of dismantling and removing
the asset and direct incremental costs to bring an asset into condition for its sale. However,
termination benefits (as defined in HKAS 19 Employee Benefits) and costs associated with
HKAS
reducing or reorganising a business following the disposal of an asset are not direct
36.28 incremental costs to dispose of the asset .
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14.3.3 Value in Use
HKAS The other measure of recoverable amount is the asset’s value in use. Value in use is defined as
36.6 the present value of the future cash flows expected to be derived from an asset.
Estimating the value in use of an asset involves the following steps:
• Estimating the future cash inflows and outflows to be derived from the asset’s
continuing use and ultimate disposal; and
• Discounting those future cash flows to their present value by applying an appropriate
discount rate.
To estimate an asset’s value in use, the following elements are taken into account:
• An estimate of the future cash flows the entity expects to derive from the asset;
• Expectations about possible variations in the amount or timing of those future
cash flows;
• The time value of money, represented by the current market risk-free rate of interest.
The risk-free rate of return is the return an investor would expect to earn on a risk-free
investment, such as the interest rate paid by a stable government on its government
bonds (over the equivalent period). Refer to Section 14.3.3.3 for further discussion of
discount rates.;
• The price for bearing the uncertainty inherent in the asset. This is an adjustment to the
discount rate or the cash flow projections that reflect the risk of the entity achieving
the projected cash flow from that asset. The adjustment factor will vary depending on
the certainty of the performance of the asset, the contracted revenue flows and the
volatility of the industry and/or market in which the asset operates; and
HKAS • Other factors, such as illiquidity, that market participants would reflect in pricing the
36.30 future cash flows the entity expects to derive from the asset.
14.3.3.1 Composition of Estimates of Future Cash Flows
Exhibit 14.7 summarises the types of future cash flows that are included in, or excluded from
(respectively), the calculation of an asset’s value in use.
Estimates of future cash flows and the discount rate reflect consistent assumptions about
price increases due to general inflation. Therefore:
• If estimates of future cash flows are estimated in nominal terms (incorporating the
effects of expected inflation), the discount rate should include the effect of price
increases due to general inflation; and
• If future cash flows are estimated in real (inflation-adjusted) terms, the discount rate
HKAS excludes the effect of price increases attributable to general inflation. This prevents
36.40 double-counting the impact of inflation.
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Treatment of types of cash flows Explanation
Included in value in use
HKAS Projections of cash inflows from the These projections reflect part of the first limb of the
36.39(a) continuing use of the asset. principle of value in use set out in HKAS 36.31(a), namely,
that value in use includes the future cash inflows to be
derived from continuing use of the asset.
Projections of cash outflows necessarily These projections reflect part of the first limb of the
incurred to generate the cash inflows from principle of value in use set out in HKAS 36.31(a), namely,
continuing use of the asset and can be that value in use includes the future cash outflows to be
directly attributed, or allocated on a derived from continuing use of the asset. Allocating cash
HKAS reasonable and consistent basis, to the outflows to an asset on a reasonable and consistent basis
36.39(b) asset. They should include: is important in ensuring an asset’s carrying amount is
compared with all of the cash inflows and outflows that
can be attributed reliably to the asset.
• Any cash outflows required to prepare When an asset is still being constructed and its carrying
the asset for use; and amount does not include all of the cash outflows to be
incurred on its acquisition, the estimate of future cash
outflows should include those expected to be incurred
before the asset is ready for use. This is to estimate future
HKAS cash flows on a consistent basis with the carrying amount
36.42 of the asset subject to the impairment test.
• Any future cash outflows required The replacement of component assets with shorter useful
to maintain the level of economic lives than the useful life of the unit or asset to which they
benefits from the asset in its current belong is considered part of the day-to-day servicing of
condition, for example, those for: the larger unit/asset.
°° The asset’s day-to-day servicing Allocating future overheads to an asset on a reasonable
(including the replacement of and consistent basis is important in ensuring an asset’s
component assets with shorter carrying amount is compared with all of the cash inflows
useful lives than the useful life and outflows that can be attributed reliably to the asset.
of the unit or asset to which they
belong); and
°° Future overheads that can be
HKAS attributed directly or allocated on
36.41 a reasonable and consistent basis
and .49 to the asset’s use.
Net cash flows, if any, estimated to be These projections reflect the second limb of the principle
received (or paid) for the disposal of the of value in use set out in HKAS 36.31(a), namely, that value
asset at the end of its useful life, after in use includes the future cash inflows and outflows to be
deducting the estimated costs of disposal. derived from ultimate disposal of the asset.
These cash flows include any cash When an asset’s development for sale is incomplete and
outflows required to prepare the asset for its carrying amount does not include all of the cash
sale. outflows to be incurred before it is ready for sale, the
estimate of future cash outflows should include those
expected to be incurred before the asset is ready for sale.
This is to estimate future cash flows on a consistent basis
HKAS with the carrying amount of the asset subject to the
36.42 impairment test.
EXHIBIT 14.7 Detailed basis of estimation of future cash flows included in value in use
measurements
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Treatment of types of cash flows Explanation
HKAS This estimated disposal value is Unlike fair value, value in use reflects the effects of any
36.53A determined in a similar way to fair value entity-specific factors.
less costs of disposal, except that the The requirement to use prices prevailing at the date of
estimated net cash flows: the estimate for similar assets that have reached the
• Use prices prevailing at the date of end of their useful life is designed to maximise the use
the estimate for similar assets that of observable evidence, bearing in mind the inherent
have reached the end of their useful difficulty of predicting future disposal values of assets with
life and have operated under similar long useful lives. The definition of ‘residual value’ in HKAS
conditions to those in which the asset 16 uses a similar principle (see Chapter 7 Property, Plant
will be used; and and Equipment).
• Adjust those prices for the effect of
future price increases due to general
HKAS inflation and specific future price
36.53 increases or decreases.
Excluded from value in use
Cash inflows from assets (such as Excluding these cash inflows is necessary to determine the
receivables and inventories) that generate estimated future cash flows on a consistent basis with the
HKAS cash inflows largely independently of the carrying amount of the asset subject to the impairment
36.43(a) asset under review test.
Cash outflows relating to obligations (such Excluding these cash outflows is necessary to determine
as payables, pensions, or provisions) that the estimated future cash flows on a consistent basis with
have been recognised as liabilities the carrying amount of the asset subject to the
HKAS impairment test. The cash outflows relate to recognised
36.43(b) liabilities rather than recognised assets.
HKAS
Cash inflows or outflows from financing The time value of money is taken into account by
36.50(a) activities, such as interest income or discounting the estimated future cash flows instead of by
and .51 interest paid including cash flows from financing activities.
HKAS
36.50(b) Income tax receipts or payments These are excluded for consistency with using a pre-tax
and .51 rate of discount.
Future cash outflows that will improve Future cash outflows that will improve or enhance the
or enhance the asset’s performance and asset’s performance, and the related cash inflows
the related cash inflows expected to arise expected to arise from such outflows, are excluded from
HKAS
from such outflows. These excluded cash value in use because future cash flows included in an
36.44(b) flows relate to expansions, refurbishments asset’s value in use are estimated for the asset in its
and .45 and other programs designed to improve current condition.
or increase production.
Future cash outflows or related cost Future cash outflows or related cost savings or benefits
savings (e.g. reductions in staff costs) or expected to arise from a future restructuring to which an
benefits expected to arise from a future entity is not yet committed are excluded because value in
restructuring to which an entity is not yet use includes future cash flows estimated for the asset in
committed. its current condition. In contrast, once an entity is
committed to a restructuring, its estimates of future cash
flows used to determine an asset’s value in use reflect the
cost savings and other benefits expected from the
restructuring though the estimated future cash outflows
relating to that restructuring are included in a
restructuring provision in accordance with HKAS 37
HKAS Provisions, Contingent Liabilities and Contingent Assets
36.44-47 (see Chapter 18).
EXHIBIT 14.7 (Continued)
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Illustrative Example 1
FlatPack Limited (FlatPack) is a furniture manufacturer. The machinery it used to
manufacture the furniture originally cost HK$1,800,000 and, on 31 December 20X0, there
is a total accumulated depreciation of HK$600,000 in relation to the machinery.
On 31 December 20X0, the machinery’s fair value is estimated as HK$1,140,000 and
the costs of disposal are estimated as HK$40,000. FlatPack’s machinery has an estimated
eight remaining years of useful life on 31 December 20X0. The net cash inflows from the
machinery for the current financial year (ending 31 December 20X0) are HK$200,000.
FlatPack estimates that its returns from the machinery will remain unchanged in
inflation-adjusted terms for the remainder of its useful life. The average of current disposal
prices for similar items of machinery at the end of their useful lives (net of costs of
disposal) is HK$80,000. The discount rate that excludes the effect of price increases due to
general inflation is 9%; the discount rate that includes the effect of price increases due to
general inflation is 12%. The specific future price increase in excess of general inflationary
increases (of 3%) is 2% per annum.
The recoverable amount is the higher of fair value less costs of disposal and value in
use. The fair value less costs of disposal in this instance is HK$1,100,000 calculated as the
fair value of HK$1,140,000 less the costs of disposal of HK$40,000.
Value in use is calculated as the sum of the present values of the future net cash
flows. Because FlatPack uses inflation-adjusted estimated net cash inflows from use
(HK$200,000), it applies a discount rate of 9% to those net cash inflows, which excludes the
effect of price increases due to general inflation.
FlatPack measures the present value of the future cash flows from disposal of the
machinery at the end of its estimated useful life (its terminal value) by adjusting its current
estimated net disposal price if it were now at the end of its useful life (HK$80,000) for the
effect of both:
• Future price increases due to general inflation; and
• Specific future price changes over and above those general inflationary effects.
However, because FlatPack excludes the effects of general inflation from its estimated
future cash flows from the machinery’s continuing use and from its discount rate, the only
inflation adjustment FlatPack makes to the current estimated net disposal price for the
item of machinery if it were at the end of its useful life (HK$80,000) is for specific future
price increases in excess of general inflationary increases. Therefore, the terminal value for
the machinery’s disposal is HK$80,000 compounded at a rate of 2% per annum for a period
of eight years, which amounts to a future value of HK$93,733.
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Illustrative Example 1 (continued)
In this case, the value in use of the machinery is HK$1,154,004 calculated as follows:
Year Cash flow Present value
(at 9%)
HK$ HK$
1 200,000 183,486
2 200,000 168,336
3 200,000 154,437
4 200,000 141,685
5 200,000 129,986
6 200,000 119,253
7 200,000 109,407
8 200,000 100,373
Terminal value 93,733 47,041
Total 1,154,004
If, instead of using inflation-adjusted cash flow estimates to measure the machinery’s
value in use, FlatPack decides to estimate its future cash flows from the machinery’s
continuing use in nominal terms, it will use a discount rate that includes the effect of price
increases due to general inflation (i.e. 12%). In addition, the terminal value will include
future price increases due to general inflation (3% per annum), with its HK$80,000 ‘current
price’ compounded at 5% per annum. The value in use applying this method will result in
the same value in use as calculated above.
Future foreign currency cash flows are estimated in the currency in which they will be
generated and are discounted using a discount rate appropriate for that currency. The
HKAS discounted amount of the foreign currency cash flows is then translated using the spot
36.54 exchange rate at the date of the value in use calculation.
14.3.3.2 Differences Between Fair Value and Value in Use Methods
Exhibit 14.8 summarises the differences between the approach and mechanics of determining
the value in use and fair value less costs of disposal.
Value in use is not a pure ‘entity-specific’ measure because it incorporates a risk adjustment
(in the estimated cash flows or the discount rate) from the viewpoint of market participants.
In other words, an asset’s value in use reflects how market participants would price the cash
flows that management expects the entity to derive from the asset.
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Value in use Fair value less costs of disposal
Calculated using the principles of HKAS 36 Calculated using the principles of HKFRS 13
Reflects the effects of factors that may be Reflects the assumptions all market participants
specific to the entity and may not be applicable would use when pricing the asset
to entities in general
If the asset is part of a cash-generating unit Can factor in net cash flows for all possible future
(see Section 14.5), value may reflect synergies uses of asset (including improvements and
and other benefits of grouping assets enhancements)
Reflects legal rights or restrictions specific to Can factor in net cash flows from highest and best
current owner use of assets
Calculated on a pre-tax basis Calculated on a post-tax basis
EXHIBIT 14.8 Difference between value in use and fair value less costs of disposal
14.3.3.3 Basis for Estimates of Future Cash Flows
The estimation of future cash flows of an asset can be highly subjective. The key principles and
guidance in Exhibit 14.9 should be applied when estimating the future cash flows incorporated
in measuring an asset’s value in use.
Principle Guidance on application of principle
Cash flow projections are to These projections should represent management’s best estimate of
be based on reasonable and the range of economic conditions that will exist over the remaining
supportable assumptions useful life of the asset. Greater weight is to be given to external
evidence. Projections must be consistent with other internally used
information (e.g. budgets, forecasts and strategy documents) and
externally published information (management discussion and
analysis, and information presented to analysts and investors).
Management assesses the reasonableness of assumptions used to
generate current cash flow projections by:
• Examining the causes of differences between past cash flow
projections and actual cash flows; and
• Ensuring the assumptions on which its current cash flow
projections are based are consistent with past actual outcomes
(provided the effects of subsequent events or circumstances that
HKAS did not exist when those actual cash flows were generated make
36.34 this appropriate).
Cash flow projections are Cash flow projections based on budgets and forecasts should not
to be based on the most cover a period greater than five years unless a longer period can be
recent financial budgets justified. This requirement is because detailed, explicit and reliable
and forecasts approved by financial budgets and forecasts for periods exceeding five years are
management generally unavailable.
Management may use cash flow projections based on financial
budgets and forecasts over a period exceeding five years if it is
confident these projections are reliable and management can
HKAS demonstrate its ability, based on past experience, to forecast cash
36.35 flows accurately over that longer period.
EXHIBIT 14.9 Principles for making cash flow projections in estimating value in use
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Principle Guidance on application of principle
Cash flow projections beyond Extrapolated projections will use a steady or declining growth rate
the most recent budget and for subsequent years unless an increasing rate can be justified. This
forecast period are to be growth rate should not exceed the long-term average growth rate for
estimated by extrapolating the the products, industries, or country or countries in which the entity
projections operates or for the market in which the asset is used unless a higher
rate can be justified. This requirement reflects that, when conditions
are favourable, competitors are likely to enter the market within that
extended time frame and restrict growth.
An increasing growth rate can be justified if it matches objective
HKAS information about patterns over a product or industry life cycle. If
36.36–.37 appropriate, the growth rate is zero or negative.
For example, traditional retail shops would normally reflect a flat or
declining growth rate, but online shopping businesses would tend to
use a higher growth rate for their assets.
EXHIBIT 14.9 (Continued)
14.3.3.4 Discount Rate
Estimated future cash flows are discounted to a net present value using a suitable discount rate.
The determination of the discount rate is a critical part of the value in use determination, as even
small adjustments to the discount rate can make a significant difference to the overall value in use.
For value in use calculations, the discount rate is a pre-tax rate that reflects current market
assessments of:
• The time value of money; and
HKAS • The risks specific to the asset for which the future cash flow estimates have not been
36.55 adjusted.
The key principle in determining the discount rate is to identify a rate that provides the return
HKAS investors would require if they were to choose an investment that would generate cash flows of
36.56 amounts, timing and risk profile equivalent to those expected to be derived from the asset.
HKAS
36.56–57 The discount to be applied is determined as shown in Exhibit 14.10:
Is there a current market transaction for a Yes Estimate rate from the
similar asset for which an implicit rate can be rate implicit in current
used to estimate the discount rate? market transaction
No
Is there a weighted average cost of capital
(WACC) publicly available for a listed entity Yes Estimate rate from the
that has a single asset (or a portfolio of assets) WACC from similar listed
similar in terms of service potential and risks entity
to the asset under review?
No
Use a surrogate rate such as:
• The entity’s WACC determined using
techniques such as Capital Asset Pricing Model;
• The entity’s incremental borrowing rate; and
• Other market borrowing rates
EXHIBIT 14.10 Determination of discount rate
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When using a surrogate rate to determine the discount rate, the following factors need to
be taken into consideration:
• The way the market would assess the specific risks associated with the asset’s
estimated cash flows;
• The exclusion of risks that are irrelevant to the asset’s estimated cash flows or for which
the estimated cash flows have been adjusted;
• The country risk, currency risk and price risk; and
HKAS 36 • The surrogate rate is adjusted to reflect a pre-tax rate if the surrogate rate is a
App. A18, 20 post-tax rate.
The discount rate is not related to the method or cost of financing the purchase of the asset
HKAS 36 because the future cash flows are unrelated to the way in which the entity financed the
App. A19 purchase of the asset.
An entity normally uses a single discount rate for the estimate of an asset’s value in use.
HKAS 36 However, separate discount rates are used for different future periods where value in use is
App. A21 sensitive to a difference in risks for different periods or to the term structure of interest rates.
14.3.4 Specific Application Issues
Section 14.3.4.1 discusses situations in which only one value (either value in use or fair
value less costs of disposal) might be used to measure an asset’s (or cash-generating unit’s)
recoverable amount. Section 14.3.4.2 discusses how to measure the recoverable amount of an
intangible asset with an indefinite useful life.
14.3.4.1 Situations in Which Only One Value Might Be Used to Measure
Recoverable Amount
When measuring a recoverable amount, some entities might calculate value in use first because
it is based mostly on internal information (such as internal budgets and forecasts) used for
asset management. If they establish an asset’s value in use exceeds its recoverable amount,
estimating the asset’s fair value less costs of disposal would be unnecessary. For some assets,
value in use might be the only measure of recoverable amount estimated because it might be
impossible to measure fair value less costs of disposal because there is no basis for making a
reliable estimate of fair value (that is, the price at which an orderly transaction to sell the asset
HKAS would take place between market participants at the measurement date under current market
36.20 conditions).
Other assets might be generic. Therefore, for those assets, it might be easy to obtain
market evidence of the asset’s fair value less costs of disposal (e.g. a genuine offer received for
the asset from an independent party) in which instances fair value less costs of disposal might
be simpler to estimate. In addition, entities holding assets that are not fully developed might
prefer to use fair value less costs of disposal to measure recoverable amount because this
measure permits the inclusion of the benefits and costs of all expansions or developments that
a market participant would factor in when pricing the asset. Therefore, in such circumstances,
the asset’s fair value less costs of disposal would generally exceed its value in use, which is
calculated using only the current condition of the asset.
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Similarly, some instances may occur where there is no reason to believe that an asset’s
value in use materially exceeds its fair value less costs of disposal. In this case, the asset’s fair
value less costs of disposal may be used as its recoverable amount. This could occur when an
HKAS asset is held for disposal because the asset’s value in use will consist mainly of the net disposal
36.21 proceeds.
14.3.4.2 Measuring the Recoverable Amount of an Intangible Asset with an Indefinite
Useful Life
HKAS 36 requires that intangible assets with an indefinite useful life be tested for impairment
at least annually by comparing its carrying amount with its recoverable amount irrespective
of whether any indication shows it may be impaired. Indefinite life intangible assets are non-
amortising assets and, therefore, are at greater risk of having a carrying amount that exceeds
recoverable amount.
Although the impairment test for indefinite life intangible assets is required at least
annually, HKAS 36 permits a shortcut approach of using the most recent detailed calculation of
an asset’s recoverable amount from a preceding period in the impairment test for an asset in
the current period, provided all of the following criteria are met:
• If the intangible asset is tested for impairment as part of a cash-generating unit, the
assets and liabilities composing that unit will not have changed significantly since the
most recent recoverable amount calculation;
• The most recent recoverable amount calculation resulted in an amount that exceeded
the asset’s carrying amount by a substantial margin; and
• Based on an analysis of events that have occurred and circumstances that have
changed since the most recent recoverable amount calculation, the likelihood that a
HKAS current recoverable amount determination would be less than the asset’s carrying
36.24 amount is remote.
Apply and Analyse 1
One of the core assets of the Plastics Division of Aurora Limited (Aurora) acquired by
FreshPak Limited (FreshPak) is an item of extrusion plant. Two years after FreshPak
acquired Aurora (i.e. 31 December 20X3), the item of plant’s carrying amount is
HK$150 million. The remaining useful life of the item of plant at that date is 15 years.
(For simplicity, the relationship of this item of plant with a cash-generating unit is
disregarded in this section. Testing for impairment of cash-generating units is addressed in
Section 14.5 of this chapter.)
On 31 December 20X3, an indication of impairment of the item of plant exists and
FreshPak estimates the item’s fair value less costs of disposal as HK$137.5 million. Because
that amount is less than the item’s carrying amount, FreshPak needs to estimate the item’s
value in use to determine whether it is impaired.
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Apply and Analyse 1 (continued)
The cash flow projections for the plant for the next seven years (up until 31 December
20Y0) in the most recent financial budgets approved by FreshPak management are set
out below. They include a budgeted cash outflow of HK$8 million in December 20X4 to
enhance the performance of the item of plant, and a budgeted resulting saving in cash
outflows of HK$5 million per annum for the following six financial years of the budget
period (from 20X5 to 20Y0).
Year ending Cash inflows Cash outflows for Net cash
31 December from sales operating expenses inflows
HK$’000 HK$’000 HK$’000
20X4 50,000 48,000 2,000
20X5 52,500 36,000 16,500
20X6 55,000 37,000 18,000
20X7 57,000 38,500 18,500
20X8 59,000 40,000 19,000
20X9 61,000 41,400 19,600
20Y0 62,800 42,700 20,100
Aurora has significant 10-year sales contracts. In addition, the budgets of Aurora used
by FreshPak have been demonstrated over many years to accurately forecast actual cash
flows from the Plastics Division, including the extrusion plant.
The average long-term growth rate of sales values for the plastic products in Hong
Kong (Aurora’s sole trading market) is 4%.
For the subsequent eight annual periods up until 31 December 20Y8, cash inflows from
sales of the plant’s products are estimated to increase by 3% per annum and cash outflows
from operating expenses of the plant are estimated to increase by 2% per annum.
Based on the current market prices of similar items of the plant that have reached
the end of their useful life and inflating that price for the remaining 15 years of the plant’s
useful life, the net cash flows to be received from disposal of the plant at the end of its
useful life are estimated to be HK$2 million.
The current pre-tax borrowing rate for an entity with the same risk profile as
FreshPak’s Plastics Division is 5.5% per annum; and the expected rate of return on equity
invested in assets similar to FreshPak’s extrusion plant is 8%. FreshPak’s debt/equity ratio
is 50/50, and the debt/equity ratio of a typical market participant holding similar assets to
the extrusion plant is 40/60.
The value in use of the item of plant is assumed not to be sensitive to differences in
risk for different periods or to the term structure of interest rates (e.g. the yield curve
is essentially flat for the remaining useful life of the item of plant). Therefore, a single
discount rate is adequate for estimating the item’s value in use.
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Apply and Analyse 1 (continued)
Required:
Analyse the information provided to:
A. Determine the duration of the period over which budgeted cash flows are to be
used to estimate the value in use of the item of plant. Explain your reasoning;
B. Determine which discount rate should be used to discount the expected future
cash flows from the item of plant to their present value. Explain your reasoning;
C. Based on your answers in (A) and (B), apply the requirements of HKAS 36 to
calculate the value in use of the item of plant on 31 December 20X3. Discuss the
process used to calculate that amount, and show all workings; and
D. Determine the recoverable amount of the item of plant.
Analysis:
An asset’s value in use is the present value of the future cash flows expected to be derived
from the asset. Estimating an asset’s value in use involves the following two steps:
1. Estimate the future cash inflows and outflows from the asset; and
2. Select and apply the appropriate discount rate to those future cash flows.
A. Budgeted and extrapolated cash flows
Because of long-term sales contracts that Aurora has in place and Aurora’s track record
of budget accuracy, the management of FreshPak concludes it is appropriate to rebut
the presumption that budgeted cash flows are to be used for a maximum of five years.
Therefore, budgeted cash flows for the entire seven-year period of the budgets (ending
on 31 December 20Y0) are used.
However, HKAS 36 specifies that estimates of future cash flows used to estimate an
asset’s value in use do not include estimated future cash inflows or outflows expected
to arise from improving or enhancing the asset’s performance. Therefore, FreshPak’s
budgeted cash flows are adjusted to exclude:
• The budgeted cash outflow of HK$8 million in December 20X4 to enhance the
performance of the item of plant; and
• The budgeted resulting savings in cash outflows of HK$5 million per annum
for the six financial years ending from 31 December 20X5 to 31 December
20Y0 inclusive.
For the subsequent periods in which the estimated cash flows for the final
budgeted period (the seventh financial year after the reporting date) are extrapolated,
the growth rate of 3% for sales is used without being constrained because it is less
than the average long-term growth rate of sales values (4%) for the plastic products in
Hong Kong. The 3% growth rate used in those extrapolations also does not exceed the
annual rate of growth during the seven-year period covered by the budget (ranging
from 3% to 5%).
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Apply and Analyse 1 (continued)
B. Discount rate
The discount rate used is a pre-tax rate of discount that reflects current market
assessments of the time value of money and the risks specific to the asset for which
the cash flow estimates have not been adjusted. The estimated cash flows in the
schedules above have not been adjusted for risk.
In this example, by 31 December 20X3, there is no longer a current market
transaction for the asset or for similar assets with which to estimate an implicit
risk-adjusted market rate of discount. Consequently, FreshPak uses a surrogate rate to
estimate the discount rate. In particular, it uses the weighted average cost of capital for
a listed entity with assets similar in terms of service potential and risks to FreshPak’s
plastics extrusion plant. If there were insufficient information to enable a reliable
estimate of that weighted average cost of capital (WACC), FreshPak would use its
incremental borrowing rate, calculated on a pre-tax basis.
To determine that weighted average cost of capital, FreshPak uses the debt/equity
ratio of a typical market participant rather than its own. This is to achieve the objective
of applying a discount rate that reflects the return that investors would require if they
were to choose an investment that would generate cash flows of the amounts, timing
and risk profile equivalent to those that FreshPak expects to derive from the item of
plant. Consequently, the WACC is calculated as (5.5% × 0.4) + (8% × 0.6) = 7%.
C. Calculation of value in use
The value in use of the item of plant is determined by applying to the net cash inflows
in the fact pattern above (adjusted to exclude the effects of enhancements to the item
of plant) the discount rate of 7% per annum, which is the WACC for a listed entity with
assets similar in terms of service potential and risks to FreshPak’s plastics extrusion
plant. The net cash inflows for each year of the useful life of the item of plant and
the present value of that amount [calculated as 1/(1 + discount rate)discount period] are
listed below. Based on those calculations, the value in use of the item of plant on
31 December 20X3 is estimated as HK$141,968,000.
Year ending Cash inflows Cash outflows Net cash Present
31 December from sales for operating inflows value
(budget periods expenses
asterisked)
HK$’000 HK$’000 HK$’000 HK$’000
20X4* 50,000 (40,000) 10,000 9,346
20X5* 52,500 (41,000) 11,500 10,045
20X6* 55,000 (42,000) 13,000 10,612
20X7* 57,000 (43,500) 13,500 10,299
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Apply and Analyse 1 (continued)
Year ending Cash inflows Cash outflows Net cash Present
31 December from sales for operating inflows value
(budget periods expenses
asterisked)
HK$’000 HK$’000 HK$’000 HK$’000
20X8* 59,000 (45,000) 14,000 9,982
20X9* 61,000 (46,400) 14,600 9,729
20Y0* 62,800 (47,700) 15,100 9,404
20Y1 64,684 (48,654) 16,030 9,330
20Y2 66,625 (49,627) 16,998 9,246
20Y3 68,623 (50,620) 18,003 9,152
20Y4 70,682 (51,632) 19,050 9,051
20Y5 72,802 (52,665) 20,137 8,941
20Y6 74,986 (53,718) 21,268 8,825
20Y7 77,236 (54,792) 22,444 8,704
20Y8 79,553 (55,888) 23,665 8,577
20Y8 Net cash inflow from disposal at 2,000 725
end of useful life
Total 141,968
Based on the calculations above, the value in use of the item of plant on
31 December 20X3 is estimated as HK$141,968,000.
D. Recoverable amount of the item of plant
The recoverable amount of the item of plant is the higher of its fair value less costs
of disposal (HK$137,500,000) and value in use (HK$141,968,000). Therefore, it is
HK$141,968,000. Because the item’s carrying amount is HK$150,000,000 the item
is impaired.
(This Apply and Analyse does not address the recognition of the impairment loss,
which is the subject of Section 14.4.)
Key Learning Point
An asset’s value in use reflects how market participants would price the cash flows that
management expects the entity to derive from the asset.
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Knowledge Check Questions
Question 2
Identify which of the following statements is untrue regarding the bases of estimation of
future cash flows when measuring an asset’s value in use in accordance with HKAS 36:
A There is a rebuttable presumption that projections of cash flows based on the most
recent financial budgets and forecasts approved by management are to cover no more
than a five-year period.
B Assumptions on which current projections of future cash flows are based must be
consistent with past actual outcomes.
C There is a rebuttable presumption that, when extrapolating projections of cash flows
beyond the period covered by the most recent financial budgets and forecasts, a steady
or declining growth rate is to be used.
D There is a rebuttable presumption that, when extrapolating projections of cash flows
beyond the period covered by the most recent financial budgets and forecasts, the
growth rate used is not to exceed the long-term average growth rate for the products,
industries, the country or countries in which the entity operates, or for the market in
which the asset is used.
Question 3
Classify the future costs below according to whether they are included in an asset’s fair
value less costs of disposal and an asset’s value in use. Include brief justification for your
conclusions, including the reasons for any differences between the treatment of particular
costs under the two measures.
• Finance costs;
• Company tax (arising on any profit on sale);
• Agent’s commission;
• Advertising costs;
• Costs incurred to bring the asset into condition for sale;
• Cost of improving or enhancing the asset’s performance;
• Stamp duty;
• Legal costs;
• Transport costs to deliver the asset to the customer; and
• Future overheads that can be attributed directly, or allocated on a reasonable and
consistent basis, to the use of the asset.
Question 4
Identify which of the following elements should not be included in the calculation of
value in use:
A Estimate of the future cash flows the entity expects to derive from the asset.
B The time value of money, represented by the current market risk-free rate of interest.
C Expectations about possible variations in the amount or timing of those future
cash flows.
D Future cash inflows or outflows expected to arise from a restructuring to which the
entity is not yet committed.
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Knowledge Check Questions (continued)
Question 5
Question Identify which of the following statements is untrue regarding the rate(s) of
discount to use when measuring an asset’s value in use:
A The rate(s) are estimated from the rate implicit in current market transactions for similar
assets, if possible.
B A pre-tax rate (rates) of discount is used.
C In the absence of better evidence, the entity’s weighted average cost of capital (WACC),
reflecting the entity’s capital structure, may be used.
D Separate discount rates for different time periods are used where value in use is
sensitive to a difference in risks for different periods or to the term structure of
interest rates.
1 4 . 4 RECOGNISING AND MEASURING
AN IMPAIRMENT LOSS
This section addresses the requirements for recognising and measuring impairment losses for
an individual asset. Recognising and measuring impairment losses for cash-generating units
and goodwill are dealt with in Section 14.5.
After determining the asset’s recoverable amount (the higher of the value in use and fair
value less costs of disposal), the recoverable amount is compared to the asset’s carrying
amount. Where the carrying amount is greater than the recoverable amount, the carrying
HKAS amount of the asset is reduced to its recoverable amount. This reduction in value is called the
36.59 impairment loss. The relationship of an asset’s carrying amount to its recoverable amount is
shown in Exhibit 14.11.
Carrying amount > Recoverable amount = Impairment loss
Recoverable amount > Carrying amount = No impairment loss
EXHIBIT 14.11 Analysis of carrying amount to recoverable amount
for impairment testing purposes
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The recognition of an impairment loss will differ depending upon whether the asset is
measured using the cost model or the revaluation model. This is discussed in Sections 14.4.1
and 14.4.2, respectively.
Sometimes, where the impairment loss is greater than the carrying amount of the asset to
which it relates, an entity recognises a liability if, and only if, that is required by another
HKAS standard. Otherwise, the maximum amount of an impairment loss is the carrying amount of
36.62 the asset.
Following the recognition of an impairment loss, the depreciation (amortisation) charge for
HKAS the asset is adjusted in future periods to allocate the asset’s revised carrying amount, less its
36.63 residual value (if any), on a systematic basis over its remaining useful life.
14.4.1 Assets Measured Using the Cost Model
For assets measured using the cost model, an impairment loss is recognised immediately in
profit or loss.
14.4.2 Assets Measured Using the Revaluation Model
If an asset is measured using the revaluation model, for example, in accordance with the
revaluation model in HKAS 16, the impairment loss is treated as a revaluation decrease in
HKAS
accordance with the relevant standard (for example, see Chapter 7: Property, Plant and
36.60 Equipment).
14.4.3 Risk of Impairment Arising Immediately upon Revaluation
The application of HKAS 36 to assets accounted for under the revaluation model may create a
risk of an impairment arising immediately upon revaluation because:
• Under a revaluation model (for example, under HKAS 16), an asset is revalued to fair
value, but;
• Under HKAS 36, the fair value limb of the definition of recoverable amount is an asset’s
fair value less its costs of disposal.
If disposal costs of an asset are significant, an impairment would arise immediately upon
revaluation to fair value unless the asset’s value in use equals or exceeds its fair value.
Exhibit 14.12 shows the principles in HKAS 36 used to determine if an asset is likely to
be impaired.
Disposal costs The recoverable amount of the revalued asset is necessarily close to or greater than
are negligible its revalued amount; this may occur if the revalued asset has been depreciated.
In this case, after the revaluation requirements have been applied, the revalued
asset is probably not impaired, and the recoverable amount need not be estimated.
Disposal The fair value less costs of disposal of the revalued asset is necessarily less than its
costs are not fair value.
negligible Therefore, the revalued asset will be impaired if its value in use is less than its
HKAS revalued amount. In this case, after the revaluation requirements have been applied,
36.5 an entity applies this standard to determine whether the asset may be impaired.
EXHIBIT 14.12 Principles to determine if an asset is likely to be impaired
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Apply and Analyse 2
SuperStorage Ltd (SuperStorage) acquires a storage building for HK$960 million on
29 December 20X5 and applies the cost model to its measurement after recognition.
Annual depreciation charges based on that cost, assuming a 40-year useful life and
(for simplicity) a residual value of zero and application of the straight-line method are
HK$24 million (calculated as HK$960 million ÷ 40 years).
On 31 December 20X8, after three years of the building’s use, the building’s balance of
accumulated depreciation is HK$72 million and its carrying amount is HK$888 million. On
that date, SuperStorage adopts the revaluation model to measure its buildings. The fair
value of the storage building on 31 December 20X8 is determined to be HK$900 million.
For simplicity of accounting entries, it is assumed that SuperStorage elects to perform this
revaluation by eliminating the accumulated depreciation at the date of the revaluation
against the building’s gross carrying amount and recognising the restatement of the asset’s
net carrying amount (by HK$12 million).
Disposal costs are estimated to be HK$1 million (commission fee) as SuperStorage
has sold buildings in the past using a trade network site and this has been a successful
low-cost option. In this case, the building’s fair value less costs of disposal on 31 December
20X8 is HK$899 million. Because no significant differences exist between the cash flows
that SuperStorage and other market participants expect to generate with the building,
the building’s value in use is unlikely to differ materially from its fair value less costs
of disposal.
In the following year (20X9), depreciation of HK$24,324,000 is recognised with respect
to the SuperStorage building (calculated as HK$900 million ÷ 37 years of remaining useful
life = HK$24,324,324, rounded to HK$24,324,000).
A downturn of real estate values in the building’s suburb occurs by 31 December 20X9,
and the fair value of the building on that date is assessed at HK$840 million. Estimated
costs of disposal remains at HK$1 million. Value in use remains likely to be materially the
same as fair value less costs of disposal.
Required:
Assume you are an accounting policy adviser for SuperStorage.
A. Evaluate whether the recoverable amount of the building needs to be estimated on
31 December 20X8 and/or 31 December 20X9;
B. Based on your evaluations in (A), advise the management of SuperStorage how
to apply the requirements of HKAS 36 to the building on 31 December 20X8
and 31 December 20X9 (including how those requirements interact with the
requirements of HKAS 16). In particular, advise whether an impairment loss has
arisen on either or both dates;
C. Show the accounting entries for your recommended treatment of the building from
the date of its acquisition; and
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Apply and Analyse 2 (continued)
D. Advise the management of SuperStorage whether the treatment of the building
should change if, on 31 December 20X9, the costs of the building’s disposal
increased to HK$15 million and therefore became material. Show the accounting
entry for any change in treatment. Assume that all other circumstances remained
the same on 31 December 20X9; in particular, the building’s value in use remained
materially the same as its fair value less costs of disposal.
Analysis:
A. 31 December 20X8
On 31 December 20X8, the revalued building’s fair value is HK$900 million and the
costs of disposal are HK$1 million. Therefore, on that date, the revalued building’s
recoverable amount could not be less than HK$899 million. In accordance with
HKAS 36, because the costs of disposal are negligible, the recoverable amount of the
revalued building is necessarily close to its revalued amount. Therefore, the revalued
building is probably not impaired, and the building’s recoverable amount need not
be estimated. In keeping with the newly adopted revaluation model for buildings, the
storage building would be revalued from its carrying amount of HK$888 million to its
fair value of HK$900 million.
B. 31 December 20X9
On 31 December 20X9, the building’s carrying amount is initially determined as
HK$875,676,000 (calculated as the opening fair value of HK$900 million minus
depreciation for the year of HK$24,324,000). On that date, the downturn of real estate
values in the building’s suburb is an observable indication that the building may be
impaired, i.e. in accordance with HKAS 36, the downturn is an observable indication
that the building’s value might have declined during the year significantly more than
the decline expected as a result of the passage of time or normal use. Therefore,
to comply with HKAS 36, the building’s recoverable amount on 31 December
20X9 needs to be estimated. Because the building’s fair value less costs of disposal
(HK$839 million) is unlikely to differ materially from its value in use, the building’s
recoverable amount is estimated as its fair value less costs of disposal. That amount
(HK$839 million) is HK$36,676,000 less than the building’s carrying amount estimated
on the basis of its previous fair value less subsequent accumulated depreciation
(HK$875,676,000).
However, the fair value and recoverable amount of the building are less than its
previous fair value less subsequent accumulated depreciation. HKAS 16 Property,
Plant and Equipment requires revaluations of assets measured under the revaluation
model to be made with sufficient regularity that the carrying amount does not differ
materially from that which would be determined using fair value at the end of the
reporting period (HK$840 million). Therefore, under HKAS 16, the building is required
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Apply and Analyse 2 (continued)
to be revalued to its fair value on 31 December 20X9. Because the building’s costs of
disposal remains unchanged at HK$1 million, on 31 December 20X9, its recoverable
amount could not be less than HK$839 million. In accordance with HKAS 36, because
the costs of disposal are negligible, the recoverable amount of the revalued building
is necessarily close to its revalued amount. Therefore, the building, once revalued to
HK$840 million, is probably not materially impaired. Consequently, consistent with
its treatment on 31 December 20X8, on materiality grounds, the building need not be
written down from its fair value for the costs of disposal.
This conclusion that an impairment loss need not be recognised has no
implications for the manner in which the revaluation decrease of the building from
HK$875,676,000 to HK$840 million is accounted for. That is, the treatment of the
revaluation decrease of the building on 31 December 20X9 would be the same
regardless of whether it were recognised under HKAS 16 or as an impairment loss
under HKAS 36 (ignoring the HK$1 million difference in amount). This is because
HKAS 36 requires an impairment loss of a revalued item of property, plant and
equipment to be treated as a revaluation decrease in accordance with HKAS 16.
C. Accounting entries reflecting the advice in (A) and (B)
The treatment recommended above is reflected in the following accounting entries for
the building:
On date of purchase (29 December 20X5)
Debit Credit
HK$’000 HK$’000
Building 960,000
Cash 960,000
(Recognition of purchase of storage building)
1 January 20X6 – 31 December 20X8 (cumulative entry)
Debit Credit
HK$ HK$
Depreciation expense – building 72,000
Accumulated depreciation – building 72,000
(Recognition of depreciation for three financial years ending on 31 December 20X8, based on
the building’s cost) [HK$24 million per annum × 3 years]
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Apply and Analyse 2 (continued)
On 31 December 20X8
Debit Credit
HK$ HK$
Accumulated depreciation – building 72,000
Building 72,000
Building 12,000
Revaluation surplus (other comprehensive income) 12,000
(Recognition of revaluation increase of building from a carrying amount of HK$888 million
to fair value of HK$900 million, including eliminating the existing balance of accumulated
depreciation against the gross carrying amount of the building before restating the building
to its fair value)
On 31 December 20X9
Debit Credit
HK$ HK$
Depreciation expense – building 24,324
Accumulated depreciation – building 24,324
(Recognition of depreciation for the year, based on the revalued carrying amount of
HK$900 million)
Debit Credit
HK$ HK$
Accumulated depreciation – building 24,324
Building 24,324
Revaluation surplus (other comprehensive income) 12,000
Revaluation loss (profit or loss) 23,676
Building 35,676
(Recognition of revaluation decrease of building from a carrying amount of HK$875,676,000
to its fair value of HK$840 million, including eliminating the existing balance of accumulated
depreciation against the gross carrying amount of the building before restating the building
to its fair value and eliminating the credit balance existing in the revaluation surplus in
respect of the building)
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Apply and Analyse 2 (continued)
D. Alternative information regarding costs of disposal
If the building’s costs of disposal had increased from HK$1 million to HK$15 million
and, therefore, became material on 31 December 20X9 (and all other circumstances
remained the same on 31 December 2019):
• The increase in the costs of disposal is a significant adverse change in the
market environment in which the entity operates. This indicates the building
might be impaired and, therefore, necessitates estimating the building’s
recoverable amount; and
• Because the building’s value in use is materially the same as its fair value less
costs of disposal, the building’s recoverable amount would have reduced
to HK$825 million (calculated as fair value of HK$840 million minus costs of
disposal of HK$15 million).
Therefore, SuperStorage would be required by HKAS 36 to recognise an
impairment loss of HK$15 million on 31 December 20X9. Because the immediately
preceding revaluation decrease to the building’s fair value of HK$840 million eliminated
the credit balance of revaluation surplus existing in respect of the building, the
additional revaluation decrease of HK$15 million arising from the impairment will be
required to be recognised as a loss in profit or loss.
The recommended recognition of an impairment loss amounting to HK$15 million
is reflected in the following accounting entry:
On 31 December 20X9
Debit Credit
HK$’000 HK$’000
Impairment loss (profit or loss) 15,000
Building 15,000
(Recognition of impairment loss on building) [calculated as fair value of HK$840 million –
recoverable amount of HK$825 million].
Key Learning Point
For an asset measured using the cost model, an impairment loss is always recognised
as a loss in profit or loss. In contrast, for an asset measured using the revaluation model
in accordance with another standard, an impairment loss is debited against any existing
credit balance of revaluation surplus for that asset via other comprehensive income; then,
to the extent of any excess of the impairment loss over that existing credit balance, the
remainder is recognised as a loss in profit or loss.
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Knowledge Check Questions
Question 6
An asset has a carrying value of HK$11 million. After conducting an impairment test, the
following information is available: the asset’s value in use is negative HK$15 million and its
fair value less costs of disposal is negative HK$22 million. Advise what is the recoverable
amount and impairment loss to be recognised, if any?
Question 7
Analyse the alternatives below and select which option best describes the treatment of an
impairment loss when an asset is measured using the revaluation model:
A A revaluation decrement.
B A revaluation increment.
C A set-off against depreciation expense.
D An addition to depreciation expense.
Question 8
Describe when an impairment will arise immediately upon revaluation under the
revaluation model
Question 9
Construction Cranes Limited (Construction Cranes) has a high-performance crane acquired
on 1 July 20X6 for a cost of HK$550 million. On 30 June 20X8, the crane’s balance of
accumulated depreciation is HK$50 million (i.e. its carrying amount is HK$500 million). The
company adopts the revaluation model for the class of assets including that crane, and
the crane is revalued to its fair value at 30 June 20X8 of HK$750 million. The crane is not
revalued to fair value on 30 June 20X9 because it is scheduled for revaluation on a cyclical
(triennial basis). Consequently, at 30 June 20X9, its carrying amount is HK$750 million
minus subsequent accumulated depreciation of HK$37.5 million. On 30 June 20X9, the
crane is identified as having an estimated impairment loss of HK$300 million. Calculate the
carrying amount of the high performance crane after deduction of the impairment loss
on 30 June 20X9, and correctly describe the classification of the impairment loss within
comprehensive income from the following options:
A HK$412.5 million, with a HK$300 million impairment recognised in profit and loss.
B HK$450 million, with HK$250 million recognised in other comprehensive income (as a
debit) and HK$50 million recognised as an expense in profit and loss.
C HK$412.5 million, with HK$250 million recognised in other comprehensive income (as a
debit) and HK$50 million recognised in profit and loss.
D HK$412.5 million, with HK$300 million recognised in other comprehensive income
(as a debit).
Question 10
ABC Limited (ABC) owns a supertanker (235,000 gross tonnage) measured using the
cost model in HKAS 16 and with a carrying amount at 20X5 of HK$495 million. That
carrying amount is calculated as the vessel’s cost of HK$840 million minus accumulated
depreciation of HK$345 million. An impairment review is required and has been
performed, and management has provided the following information:
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Knowledge Check Questions (continued)
• ABC plans to refurbish the supertanker in 20X6, which will make it suitable for more
customers’ loading facilities. This has been factored into the budget and forecast
prepared at the end of 20X5 and shows a net present value of HK$580 million
(after tax);
• A net present value calculation of future cash flows for the supertanker is provided
to ABC’s bank, which excludes the cash flows expected from the refurbishment and
shows a net present value of HK$400 million;
• ABC receives an offer to buy the supertanker from DEF Limited (DEF) for
HK$500 million. It would incur costs of disposal as follows: redundancy costs
for crew of HK$10 million; stamp duty of HK$50 million; and agent’s fees of
HK$20 million; and
• When assessing the offer by DEF, the management of ABC researches the price of
similar vessels and finds that a smaller supertanker of 125,000 gross tonnage was
sold two years ago for HK$450,000 (net of disposal costs)
Evaluate the information to:
• Determine the recoverable amount of the supertanker; and
• Advise which journal entries are required to recognise an impairment loss, if any.
1 4 . 5 CASH-GENERATING UNITS AND GOODWILL
Up to this point of the chapter, we have presumed an asset can be tested for impairment
separately; this is consistent with the principle that impairment testing occurs at the lowest
possible level of aggregation of assets. However, many assets will not be able to be tested
separately because they do not generate cash inflows largely independently of other assets.
In Section 14.5.1, we will see how HKAS 36 identifies the level at which impairment testing
for these assets occurs. Sections 14.5.2 and 14.5.3 discuss the mechanics of comparing the
carrying amounts of assets with their recoverable amount at that higher level of aggregation
and how impairment losses identified for a group of assets are allocated to individual assets
composing the group. Sections 14.5.4 and 14.5.5 discuss two particular asset types that cannot
be tested for impairment separately, namely corporate assets and goodwill, and how they are
allocated to groups of assets and tested for impairment.
14.5.1 Identifying the Cash-generating Unit to Which an Asset Belongs
An asset’s value in use cannot be estimated separately from the value in use of other assets if:
• The asset does not generate cash inflows largely independently of other assets; and
• The asset’s fair value less costs of disposal cannot be used as a proxy for its value in
use. This might occur where costs of disposal are significant or the asset is expected
to continue to be used for a significant period and creates entity-specific synergistic
benefits not reflected in the asset’s fair value.
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If an individual asset’s value in use cannot be estimated separately, and the asset’s fair
value less costs of disposal is less than its carrying amount, its recoverable amount cannot be
estimated separately. Instead, its recoverable amount must be determined for the smallest
identifiable group of assets that includes the asset in question and generates cash inflows
HKAS
36.22 and largely independent of the cash inflows from other assets or groups of assets. This group of
.67 assets is called the asset’s cash-generating unit.
The decision-making process for determining the level of impairment testing is summarised
in Exhibit 14.13.
Is the asset used to
generate cash inflows
that are largely
independent of those No
from other assets or
groups of assets? Can the asset’s value in
use be estimated to be
close to its fair value less
Yes costs of disposal?
Yes No
Is the asset’s fair value
less costs of disposal
greater than, or equal
to, its carrying amount?
Yes
No
Perform impairment Perform impairment
testing at the individual testing at the
asset level cash-generating unit level
Identify the asset’s cash-generating
unit, i.e. the smallest identifiable group
of assets that includes the asset and
generates cash inflows largely independent
of the cash inflows from other assets or
groups of assets
EXHIBIT 14.13 Determination of level of impairment
testing (asset or cash-generating unit)
Application of the decision-making process for determining the level of impairment testing
(summarised in Exhibit 14.13) is illustrated in Illustrative Example 2 below.
Illustrative Example 2
Excelsior Child Care Limited (Excelsior) operates two child-care centres (Centre A and
Centre B) that generate cash inflows independently of each other. Management of the
child-care centres manage the centres separately, and cash flows are identifiable for
each centre. Each centre contains the following assets, which do not generate cash
inflows independently of the other assets used in that centre. Therefore, Centres A and B
are identified as cash-generating units.
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Illustrative Example 2 (continued)
Assets Centre A Centre B
Carrying Fair value Carrying Fair value
amount less costs amount less costs
of disposal of disposal
HK$’000 HK$’000 HK$’000 HK$’000
Building 25,100 33,500 28,300 25,500
Equipment 1,250 1,400 1,190 1,300
Furniture 400 450 350 375
Total 26,750 35,350 29,840 27,175
Due to a new law that will increase the cost of operating child-care centres, Excelsior
tests the assets of Centres A and B (which are measured under the cost model) for
potential impairment. There is significant doubt about whether those assets’ value in use
would be close in amount to their fair value less costs of disposal. The assets of Centre A
were acquired less recently than those of Centre B, and the data above reflect that their
market prices have risen significantly since acquisition.
The decision tree in Exhibit 14.13 is repeated below and annotated to show how each
asset in Centre As and B, respectively, is treated.
Centre A
Is the asset used to
generate cash inflows No: building, equipment,
that are largely furniture
independent of those
from other assets or
groups of assets? Can the asset’s value in
use be estimated to be
close to its fair value less
Yes costs of disposal?
No: building,
Yes equipment, furniture
Is the asset’s fair value
less costs of disposal
greater than, or equal
to, its carrying amount?
Yes: building,
equipment, No
furniture
Perform impairment Perform impairment
testing at the individual testing at the
asset level cash-generating unit level
Identify the asset’s cash-generating
unit, i.e. the smallest identifiable group
of assets that includes the asset and
generates cash inflows largely independent
of the cash inflows from other assets or
groups of assets
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Illustrative Example 2 (continued)
Each asset of Centre A is tested for impairment at the individual asset level. Because
the carrying amount of each of those assets is exceeded by its fair value less costs of
disposal, there is no need to estimate the value in use of that cash-generating unit.
Centre B
Is the asset used to
generate cash inflows No: building, equipment,
that are largely furniture
independent of those
from other assets or
groups of assets? Can the asset’s value in
use be estimated to be
close to its fair value less
Yes costs of disposal?
No: building,
Yes equipment, furniture
Is the asset’s fair value
less costs of disposal
greater than, or equal
to, its carrying amount?
Yes: equipment,
furniture No: building
Perform impairment Perform impairment
testing at the individual testing at the
asset level cash-generating unit level
Identify the asset’s cash-generating
unit, i.e. the smallest identifiable group
of assets that includes the asset and
generates cash inflows largely independent
of the cash inflows from other assets or
groups of assets
Centre B’s equipment and furniture are tested for impairment at the individual asset
level because, for each of them, their carrying amount is exceeded by their fair value less
costs of disposal. However, the carrying amount of Centre B’s building exceeds its fair
value less costs of disposal. Consequently, estimating the value in use of all the assets of
Centre B is necessary to identify whether the building is impaired.
Identifying an asset’s cash-generating unit requires judgement. The outcome of such
judgements can affect whether an impairment loss is recognised. Such judgements are based
on a number of factors including:
• How management monitors the entity’s operations, e.g. product lines, businesses,
individual locations, districts or regional areas; or
• How management makes decisions about continuing or disposing of the entity’s assets
HKAS and operations, e.g. how the entity determines its budgets, forecast and strategy for the
36.69 various parts of the business.
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Apply and Analyse 3
Pamper Motels Limited (Pamper) operates a chain of four motels located in different
cities. It has identified one cash-generating unit comprising all four of its motels on the
grounds that:
• Supplies of linen, cleaning products and staff resources are purchased centrally by
Pamper’s administration unit;
• Pricing decisions, marketing, advertising, repairs and maintenance and most
administration activities are performed on a whole-of-entity basis; and
• Internal management reporting is organised to measure the performance of the
motels collectively.
Required:
Determine whether Pamper has correctly identified the level of its cash-generating unit(s).
Justify your conclusion with reasoning.
Analysis:
An entity identifies each of its cash-generating units as the smallest identifiable group of
assets that generates cash inflows largely independent of the cash inflows from other
assets or groups of assets. Each of Pamper’s motels is located in a different city and,
therefore, is likely to have different customer bases; i.e. it is likely to generate cash inflows
independently of the cash inflows from the other motels. Therefore, Pamper has likely
incorrectly identified only one cash-generating unit comprising all four of its motels. Each
motel (including each of its assets) is likely to be a cash-generating unit.
HKAS 36 requires identification of cash-generating units on the basis of independent
cash inflows rather than independent net cash inflows; therefore, outflows on shared
marketing and other costs are not considered.
An example of where judgement might be required is where an entity has multiple business
units and particularly where some of those operations are horizontally or vertically integrated.
Identifying which assets should be included in the cash-generating unit can be difficult because
assets might be shared between cash-generating units. For example, for FreshPak Limited
(FreshPak) in the Opening Case, if a distribution centre is used by the plastics and glass
divisions, the company must determine which cash-generating unit the distribution centre
should be allocated to.
A group of assets that work together to generate cash inflows (a cash-generating unit)
would include a smaller cash-generating unit if an active market exists for the output produced
HKAS by a component asset or group of assets. This is the case even if some or all of its output is
36.70 used internally because the output could be sold externally into that active market and
generate its own independent cash flows even if the entity is structured to use that output
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internally. An active market is defined by HKFRS 13 as ‘A market in which transactions for the
asset or liability take place with sufficient frequency and volume to provide pricing information
on an ongoing basis.’
Where an entity is vertically integrated or has a number of steps in its production or
revenue-generating process, careful consideration needs to be given as to whether an active
market exists at interim stages of the production process. For example, consider a soft drink
manufacturer that, as part of its production process, produces a syrup to use in its final
bottled and canned products. However, it also sells that syrup to hotels and other hospitality
venues. The machines used to produce the syrup are, therefore, a separate cash-generating
unit even though most of that syrup is used in the manufacturer’s normal soft drink
production process.
Apply and Analyse 4
In the Opening Case, FreshPak Limited (FreshPak) operates its Footwear Division, which
produces shoes in three different countries. The cash inflows from the sales of shoes are
independent of the cash inflows from the products of FreshPak’s other divisions. Factory
1 in one country produces tanned leather exclusively for the manufacture of shoes in
Factories 2 and 3 in two other countries. The combined capacity of Factories 2 and 3 is not
fully utilised. FreshPak’s shoes are sold worldwide in active markets from either Factory
2 or 3. Utilisation levels and, therefore, cash inflows of Factories 2 and 3 depend on the
allocation of sales between the two factories. There is an active market for the tanned
leather produced in Factory 1 even though all of that leather is used internally in the
production of shoes.
Required:
Determine which factories of FreshPak constitute a cash-generating unit. Justify your
conclusion with reasoning.
Analysis:
Factory 1 is a separate cash-generating unit because an active market exists for its product
(tanned leather). Although an active market exists for the shoes produced by Factories
2 and 3, those factories are not identified as cash-generating units separate from one
another. This is because the cash inflows from Factories 2 and 3 depend on the allocation
of production between those two factories. Consequently, the future cash inflows for
Factories 2 and 3 will probably not be determined individually. Therefore, Factories 2 and
3 likely form the smallest identifiable group of assets that generates largely independent
cash inflows.
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HKAS In addition, HKAS 36 requires that cash-generating units be identified consistently from
36.72 period to period for the same asset or types of assets, unless a change is justified.
Assessments of whether a particular asset should be tested for possible impairment
separately or as part of a cash-generating unit can change over time. This is illustrated in
Illustrative Example 3 below.
Illustrative Example 3
To date, an item of equipment at a manufacturing site has been tested for possible
impairment as part of a cash-generating unit. If an expected reduction in future
production causes the item of equipment to be identified as a surplus asset and held for
disposal, the item should now be assessed for possible impairment as an individual asset
because the primary source of cash inflows from the asset will be the net proceeds from
disposal. Consequently, the item’s value in use is unlikely to differ materially from its fair
value less costs of disposal, which is assessed at an individual asset unit of account.
14.5.2 Recoverable Amount and Carrying Amount of a
Cash-generating Unit
The impairment testing process follows the same principles for a cash-generating unit as for an
individual asset.
When comparing the recoverable amount with the carrying value of the cash-generating
unit, it is important to ensure that the correct assets of the cash-generating unit are included
in the assessment of carrying value to provide a meaningful comparison. This means that the
assets (and liability if permitted in certain circumstances – refer below) included in the carrying
amount of the cash-generating unit must be consistent with the basis of inclusion of cash
inflows and cash outflows included in the determination of the recoverable amount.
HKAS
36.76–79 Accordingly, the following guidelines outlined in Exhibit 14.14 should be applied.
Assets Liabilities
General principle Include the carrying amount of only Exclude the carrying amount of any
those assets that can be attributed recognised liability.
directly, or allocated on a reasonable and
consistent basis, to the cash-generating
unit and will generate the future
cash inflows used in determining the
cash-generating unit’s value in use
Principle-based – The only exception is where
exception the recoverable amount of the
cash-generating unit cannot be
determined without consideration of
a liability because it is integral to that
unit; that is, they will always be sold
together (for example, environmental
contamination liability).
EXHIBIT 14.14 Guidelines to determine the assets and liabilities to be included in the carrying
amount of a cash-generating unit
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In relation to the ‘principle-based exception’ set out in Exhibit 14.14, the disposal of assets
composing a cash-generating unit might require the buyer to assume a liability in which case
only a single ‘fair value less costs of disposal’ amount would be available for the assets
composing that cash-generating unit and the intrinsically related liability. That measure of fair
HKAS value less costs of disposal should be compared with the net carrying amount of the assets and
38.78 the liability. This is illustrated in Illustrative Example 4 below.
Illustrative Example 4
Golden Mile Limited (Golden Mile) operates a mine and is legally required to restore
its mine site on completion of mining operations. The restoration cost includes the
cost of replacing the mine overburden, which was necessarily removed before mining
operations began. A provision for restoration costs was recognised upon removing the
overburden. The amount provided was capitalised as part of the cost of the mine and
is being depreciated over the mine’s useful life. The carrying amount of the provision
for restoration costs is HK$330 million, which is calculated as the present value of the
restoration costs.
Golden Mile is testing its mine for impairment. The cash-generating unit for the mine
is the mine as a whole. Golden Mile has received several offers to buy the mine for a price
of approximately HK$1,500 million. This price reflects the buyer assuming the obligation to
restore the overburden. The mine’s estimated costs of disposal are negligible. The mine’s
value in use is approximately HK$1,750 million, excluding restoration costs. The mine’s
carrying amount is HK$1,630 million.
The fair value less costs of disposal of the cash-generating unit is HK$1,500 million.
This amount includes restoration costs that have been incorporated in the provision
(i.e. the fair value of the mine, without the restoration provision included in the
cash-generating unit, is HK$1,830 million). Consequently, the cash-generating unit’s value
in use is determined after incorporating the restoration costs and is estimated to be
HK$1,420 million (composed of HK$1,750 million minus HK$330 million). The carrying
amount of the cash-generating unit is HK$1,300 million, which is the carrying amount of
the mine (HK$1,630 million) minus the carrying amount of the provision for restoration
costs (HK$330 million). Therefore, the recoverable amount of the cash-generating
unit, measured at HK$1,500 million (its fair value less costs of disposal), exceeds its
carrying amount.
A practical exception to the principles set out in Exhibit 14.14 is that if, for practical reasons,
cash flow forecasts used in estimating the recoverable amount of a cash-generating unit also
include cash flows stemming from assets not belonging to that unit (for example, receivables
and other financial assets) or liabilities (for example, accounts payable, pensions and other
provisions), the carrying amount of the cash-generating unit will be:
• Increased by the carrying amount of those assets; and
• Decreased by the carrying amount of those liabilities.
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Some assets such as goodwill or corporate assets cannot be allocated to the
cash-generating unit on a reasonable and consistent basis even though they contribute to the
HKAS estimated future cash flows of a cash-generating unit. This is discussed further below in
36.77 Sections 14.5.4 and 14.5.5.
14.5.3 Recognition of Impairment Loss for a Cash-generating Unit
Given the number and different types of assets which may form part of a cash-generating unit
(including goodwill), it is important to understand the rules which apply to the allocation of any
impairment loss which may arise.
14.5.3.1 Allocating Impairment Loss to Assets of a Cash-generating Unit
An impairment loss is to be recognised for one or a group of cash-generating units to which a
corporate asset (see Section 14.5.4) or goodwill (see Section 14.5.5) has been allocated when
HKAS the carrying amount exceeds the recoverable amount of that cash-generating unit or group of
36.104 cash-generating units.
The impairment loss is allocated to reduce the carrying amount of the assets of the
cash-generating unit or group of cash-generating units in the following order:
1. Reduce the carrying amount of any goodwill allocated to the cash-generating unit or
group of units; and
HKAS 2. Reduce the carrying amount of other assets of the cash-generating unit or groups of
36.104 cash-generating units on a pro rata basis.
When allocating the impairment loss to the non-goodwill assets, the carrying amount of any
asset is not to be reduced below the highest of:
• Its fair value less costs of disposal (if measurable);
• Its value in use (if determinable); and
• Zero.
The amount of the impairment loss that would otherwise have been allocated to the
asset is allocated pro rata to the other assets of the cash-generating unit or group of
cash-generating units.
If it is impracticable to estimate the fair value less costs of disposal or value in use for the
purposes of the allocation process described above, the impairment will be applied on an
arbitrary basis to the assets other than goodwill because all assets of a cash-generating unit
work together.
Once the impairment loss has been allocated in the manner described above to each asset
in the cash-generating unit (or group of cash-generating units), the impairment loss for each
affected asset is recognised (either in profit or loss or in other comprehensive income) in the
manner described in Sections 14.4.1 and 14.4.2 (as applicable).
If a subsidiary or part of a subsidiary is a cash-generating unit and has a non-controlling
interest, an impairment loss for the unit will be allocated between the parent and the no rolling
HKAS interest on the same basis as that on which the profit or loss is allocated between those
36.C6 interests.
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14.5.4 Corporate Assets
Section 14.5.4.1 discusses the nature of corporate assets, and Section 14.5.4.2 discusses how to
allocate corporate assets to cash-generating units.
14.5.4.1 Nature of Corporate Assets
Corporate assets comprise any asset that is shared across an organisation. Typically, corporate
assets include the following: offices used as a group or division headquarters; shared
information technology assets, such as data centres; corporate or global brands; disaster
recovery centres; research centres servicing multiple divisions; or call centres.
Impairment testing of corporate assets can be difficult because:
• Corporate assets contribute to future cash flows of cash-generating units but only in
conjunction with other assets or groups of assets, and
HKAS • Allocating their carrying amount to cash-generating units on a non-arbitrary basis can
36.100 be difficult.
14.5.4.2 Allocating Corporate Assets to Cash-generating Units
A corporate asset is tested for impairment if there is an indication it may be impaired. Because
determining the recoverable amount of a corporate asset is difficult (unless management have
decided to dispose of it), the corporate asset needs to be incorporated into the cash-generating
unit’s impairment testing process. This will occur at the most appropriate cash-generating unit
HKAS (if possible) or to the lowest group of cash-generating units that enjoy the benefits of that
36.101 corporate asset. Any impairment loss is recognised in the manner explained in Section 14.5.3.1.
HKAS The process of assessing the appropriate treatment of corporate assets for impairment
36.102 testing is shown at Exhibit 14.15.
If a portion of the carrying amount of a
corporate asset cannot be allocated on
reasonable and consistent basis to a CGU
Compare the carrying amount of the unit
(excluding the corporate asset) with its
recoverable amount and recognise any
impairment loss
Identify the smallest group of CGUs that
If a portion of the carrying
includes the CGU under review and to
amount of a corporate asset
which a portion of the carrying amount
can be allocated on a reasonable
of the corporate asset can be allocated
and consistent basis to that CGU
on a reasonable and consistent basis
Compare the carrying amount of that group
Compare the carrying amount
of CGUs (including the portion of the
of the unit (including the portion
carrying amount of the corporate asset
of the corporate asset) with
allocated to that group of CGUs) with the
recoverable amount
recoveable amount of the group of CGUs
Recognise any impairment loss in Recognise any impairment loss in
accordance with Section 5.3.1 accordance with Section 5.3.1
EXHIBIT 14.15 Treatment of corporate assets for impairment testing
purposes
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14.5.5 Goodwill Impairment
Goodwill acquired in a business combination is recognised in accordance with HKFRS 3 (Revised)
Business Combinations (see Chapter 29). Section 14.5.5.1 discusses how to allocate goodwill to
cash-generating units. Section 14.5.5.2 discusses testing for impairment of cash-generating units
to which goodwill has been allocated, including the prescribed timing of those tests.
14.5.5.1 Allocating Goodwill to Cash-generating Units
Testing goodwill independently from other assets is impossible because goodwill does not
generate cash flows of its own but works in conjunction with other cash-generating units or
groups of cash-generating units. Therefore, goodwill needs to be allocated to cash-generating
units or groups of cash-generating units for impairment testing.
To test goodwill for impairment in a way that reflects the way the goodwill works within an
entity, goodwill recognised at the date of acquisition must be allocated to:
• Each of the cash-generating units which are expected to benefit from the synergies of
the acquisition; or
HKAS • A collection of cash-generating units which are expected to benefit from the synergies
36.80-81 of the acquisition.
This is explained in Exhibit 14.16.
Goodwill acquired Does the goodwill Allocate goodwill to
Yes
in a business relate to a single that cash-generating
combination cash-generating unit? unit
No
Multiple cash-generating units benefit from the goodwill
Can the goodwill be allocated to each of those Yes Allocate a portion of the goodwill to
cash-generating units on a non-arbitrary basis? each of those cash-generating units
No That group of
cash-generating units:
• Represents the lowest level
• Allocate the goodwill collectively to the group of within the entity at which
cash-generating units that benefit from it goodwill is monitored for
• Do not allocate any of the goodwill to individual internal management
cash-generating units purposes; and
• Is not larger than an
operating segment*
Step 1: for each of these cash-generating units,
compare its carrying amount (excluding goodwill)
with its recoverable amount
*The operating segment is as defined in
Step 2: Compare the carrying amount of the group HKFRS 8 (before any aggregation of similar
of cash-generating units (including goodwill) with operating segments into a single operating
their recoverable amount segment for disclosure purposes)
EXHIBIT 14.16 Allocating goodwill to cash-generating units
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FINANCIAL REPORTING
When applying HKFRS 3 (Revised) Business Combinations (see Chapter 29), an acquirer of a
business measures goodwill as the amount by which the net acquisition date amount of the
identifiable assets acquired and liabilities assumed is exceeded by the sum of:
• The consideration transferred;
• The amount of any non-controlling interest in the acquiree; and
• In a business combination achieved in stages, the acquisition-date fair value of the
acquirer’s previously held equity interest in the acquiree (this complication is excluded
from the discussion and examples below in this section).
If an entity measures non-controlling interests in a subsidiary as its proportionate interest
in the subsidiary’s net identifiable assets at the acquisition date, rather than at fair value, when
allocating goodwill to a cash-generating unit the entity grosses up:
• The carrying amount of goodwill allocated to the unit; and
• The related goodwill attributable to the non-controlling interest.
This grossing-up step is taken because goodwill attributable to the non-controlling interest
is included in the recoverable amount of the related cash-generating unit but is not recognised
in the parent’s consolidated financial statements. Grossing up for goodwill attributable to the
HKAS 36.C1
non-controlling interest results in a valid comparison between the cash-generating unit’s
and C4 recoverable amount and its adjusted carrying amount.
This grossing up of goodwill is illustrated in Apply and Analyse 5 in Section 14.5.5.2 (the
section covering the testing of cash-generating units with goodwill for impairment).
14.5.5.2 Testing Cash-generating Units with Goodwill for Impairment
The standard has specific requirements for the approach to be taken when testing:
• Cash-generating units to which goodwill has been allocated; and
• Cash-generating units to which goodwill relates to but is not allocated to, as would be
the case if goodwill was allocated to a group of cash-generating units.
The prescribed testing approach and the prescribed timing of those tests are shown in
Exhibit 14.17.
Relationship of Impairment testing process Timing of testing to be performed
goodwill to cash-
generating unit
Goodwill has been Impairment test to be performed Test annually (at any time during the
HKAS allocated to a cash- by comparing the carrying year, providing it is at the same time
36.90 generating unit amount of the cash-generating each year) and whenever an indicator
unit, including the goodwill with exists.
HKAS the recoverable amount of If an asset within the cash-generating
36.90 the unit unit is to be tested at the same time as
HKAS the cash-generating unit, the asset is to
36.97 be tested for impairment first.
EXHIBIT 14.17 Prescribed method and timing of impairment testing for cash-generating units
with goodwill
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Relationship of Impairment testing process Timing of testing to be performed
goodwill to cash-
generating unit
Goodwill has been (i) Impairment test to be (i) When there is an indicator
allocated to a group of performed on a present
cash-generating units cash-generating unit by (ii) Test annually (at any time during
but not allocated to any cash-generating unit basis by the year, providing it is at the same
specific cash-generating comparing the carrying time each year) and whenever an
unit (i.e. goodwill is amount of each indicator exists
HKAS ‘related’ to a cash-generating unit,
36.88 cash-generating unit). excluding the goodwill with If a cash-generating unit within the
the recoverable amount of group of cash-generating units is to
HKAS that cash-generating be tested at the same time as the
36.88 unit; and group of cash-generating units,
the individual cash-generating unit
(ii) As a separate process,
HKAS will have to be tested for
36.97 perform an impairment test
impairment first.
of the group of
cash-generating units and
goodwill by comparing the
carrying amount of the group
of cash-generating units and
goodwill with the recoverable
amount of that the group of
HKAS cash-generating units and
36.90 goodwill.
EXHIBIT 14.17 (Continued)
The intent of the timing of the tests is to ensure that, regardless of where goodwill is
allocated, it will be tested annually and at the same time each year.
Although HKAS 36 requires cash-generating units to which goodwill has been allocated to
be tested for impairment annually, it does permit different cash-generating units to perform
this annual impairment test at different times during the year. For example, if cash-generating
units A, B and C each had goodwill allocated to them, they could perform their annual
HKAS impairment tests in March, July and October respectively, provided that each unit’s test is
36.96 performed at the same time every year.
However, if any portion of the goodwill allocated to a cash-generating unit was acquired in
HKAS a business combination during the current annual period, that cash-generating unit is required
36.96 to be tested for impairment before the end of the current annual period.
HKAS 36 includes a practical expedient to provide impairment testing efficiencies for cash-
generating units to which goodwill has been allocated if circumstances remain substantially
unchanged. Entities can use the most recent detailed calculation of the recoverable amount
from a preceding period provided all of the following criteria are met:
• There is no significant change to the assets and liabilities comprising the
cash-generating unit because the most calculation was completed;
• The previous impairment test showed the recoverable amount being greater than the
carrying amount of the cash-generating unit by a substantial margin; and
• The likelihood that a current calculation of recoverable amount would be less than the
HKAS current carrying amount of the unit is unlikely based on management’s analysis of
36.99 events and circumstances since the most recent calculation.
773
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FINANCIAL REPORTING
As stated in Section 14.5.5.1, the standard specifies the measurement of goodwill for
impairment testing purposes when an entity measures non-controlling interests in a subsidiary
as its proportionate interest in the subsidiary’s net identifiable assets at the acquisition date,
rather than at fair value. This is illustrated in Apply and Analyse 5 below. Apply and Analyse
6 below contrasts that treatment with the treatment required by the standard when non-
controlling interests are measured at fair value.
Apply and Analyse 5
Parent acquires a 90% ownership interest in Subsidiary A for HK$2,700,000 on 31 May
20X0. On that date, the identifiable net assets of Subsidiary A have a fair value of
HK$2,400,000. Parent elects to measure the non-controlling interests in Subsidiary A as
the proportionate interest in Subsidiary A’s net identifiable assets, being HK$240,000
(calculated as 10% of HK$2,400,000). Goodwill arising from the acquisition of Subsidiary A
is HK$540,000, calculated as the difference between:
• The sum of the consideration transferred and the amount of the non-controlling
interests (HK$2,700,000 + HK$240,000, i.e. HK$2,940,000); and
• The net identifiable assets (HK$2,400,000).
Subsidiary A is a cash-generating unit. Because other cash-generating units of Parent
are expected to benefit from the synergies of the business combination, the goodwill
of HK$300,000 related to those synergies has been allocated to other cash-generating
units within Parent. The Subsidiary A cash-generating unit is tested for impairment on
31 December 20X0.
On 31 December 20X0, the recoverable amount of Subsidiary A as a cash-generating
unit is measured as HK$2,450,000. The carrying amount of the net assets of Subsidiary A,
excluding goodwill, is calculated as HK$2,500,000.
Profit or loss is allocated to the controlling and non-controlling interests in Subsidiary A
on the basis of the relative ownership interests.
Required:
For the reporting date of 31 December 20X0:
A. Apply the requirements of HKAS 36 for the grossing up of goodwill attributable
to non-controlling interests in Subsidiary A to calculate the goodwill allocated to
Subsidiary A to test the carrying amount of that cash-generating unit timing for
impairment;
B. Based on the calculation in (a), calculate the amount of any impairment loss
with respect to Subsidiary A and demonstrate to which assets within that
cash-generating unit any impairment loss is allocated; and
C. Demonstrate the calculation of the impairment loss for Subsidiary A that is
attributable to the recognised assets of that cash-generating unit and, therefore, is
the amount of the impairment loss recognised by Parent in respect of Subsidiary A.
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Apply and Analyse 5 (continued)
Analysis:
Because cash inflows generated by goodwill attributable to the 10% non-controlling
interests in Subsidiary A are included in Subsidiary A’s recoverable amount of
HK$2,450,000 but the goodwill attributable to those non-controlling interests has not
been recognised in the consolidated financial statements of Parent, Subsidiary A’s carrying
amount is grossed up to include goodwill attributable to the non-controlling interests. The
resulting grossed-up amount is then compared with Subsidiary A’s recoverable amount
(HK$2,450,000).
The first step in grossing up Subsidiary A’s carrying amount to include goodwill
attributable to the non-controlling interests is to calculate the goodwill attributable to
Parent’s 90% interest in Subsidiary A, at the acquisition date, after allocating goodwill
to other cash-generating units within the group controlled by Parent. The goodwill
attributable to Parent’s 90% interest in Subsidiary A is HK$540,000. The goodwill to other
cash-generating units is HK$300,000. The net amount remaining is HK$240,000.
The second step is to calculate the goodwill attributable to the 10% non-controlling
interests in Subsidiary A at the acquisition date. This is calculated as HK$240,000 ×
(10% ÷ 90%) = HK$26,667. This is added to the carrying amount of goodwill in the following
table setting out the calculation of any impairment loss in respect of Subsidiary A:
Goodwill of Net identifiable Total
Subsidiary A assets
HK$ HK$ HK$
Carrying amount 240,000 2,500,000 2,740,000
Unrecognised non-controlling 26,667 – 26,667
interests
Adjusted carrying amount 266,667 2,500,000 2,766,667
Recoverable amount (2,450,000)
Impairment loss 316,667
Consistent with Section 14.5.3.1, the impairment loss of HK$316,667 is allocated
to the assets of Subsidiary A (the cash-generating unit) by reducing the carrying
amount of goodwill first. Accordingly, the entire carrying amount of goodwill allocated
to Subsidiary A (HK$266,667) is written off before reducing the carrying amounts
of Subsidiary A’s identifiable assets. As mentioned in Section 14.5.3.1, the goodwill
impairment loss is allocated to the controlling and non-controlling interests in
Subsidiary A on the same basis as that on which profit or loss is allocated. In this
example, profit or loss is allocated on the basis of the relative ownership interests.
Because goodwill is recognised only to the extent of Parent’s 90% ownership interest in
Subsidiary A, Parent recognises only 90% of the goodwill impairment loss of HK$266,667
(i.e. Parent recognises only HK$240,000).
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FINANCIAL REPORTING
Apply and Analyse 5 (continued)
The remaining impairment loss (HK50,000) is recognised by reducing the carrying
amounts of Subsidiary A’s identifiable assets. This is shown in the table below, which
presents the allocation of the impairment loss between goodwill and the net identifiable
assets of Subsidiary A:
Recognised goodwill Net identifiable Total
of Subsidiary A assets
HK$ HK$ HK$
Carrying amount 240,000 2,500,000 2,740,000
Impairment loss (240,000) (50,000) (290,000)
Carrying amount after – 2,450,000 2,450,000
impairment loss
Apply and Analyse 6
Parent acquires a 90% ownership interest in Subsidiary A for HK$2,700,000 on 31 May
20X0. On that date, the identifiable net assets of Subsidiary A have a fair value of
HK$2,400,000. Parent elects to measure the non-controlling interests in Subsidiary A at fair
value, which is HK$280,000.
Subsidiary A is a cash-generating unit and is tested for impairment on 31
December 20X0.
On 31 December 20X0, the recoverable amount of Subsidiary A as a cash-generating
unit is measured as HK$2,600,000. The carrying amount of the net assets of Subsidiary A,
excluding goodwill, is calculated as HK$2,500,000.
Assume that HK$300,000 of the goodwill is related to other cash-generating units
within the Parent.
Profit or loss is allocated to the controlling and non-controlling interests in Subsidiary A
on the basis of the relative ownership interests.
Required:
For the reporting date of 31 December 20X0:
A. Apply the requirements of HKAS 36 to calculate the goodwill allocated to
Subsidiary A to test the carrying amount of that cash-generating unit timing for
impairment; and
B. Based on the calculation in (A), calculate the amount of any impairment loss
with respect to Subsidiary A and demonstrate to which assets within that
cash-generating unit any impairment loss is allocated.
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Apply and Analyse 6 (continued)
Analysis:
Goodwill arising from the acquisition of Subsidiary A is HK$580,000, calculated as the
difference between:
• The sum of the consideration transferred and the amount of the non-controlling
interests (HK$2,700,000 + HK$280,000, i.e. HK$2,980,000); and
• The net identifiable assets (HK$2,400,000).
Because other cash-generating units of Parent are expected to benefit from the
synergies of the business combination, the goodwill of HK$300,000 related to those
synergies has been allocated to other cash-generating units within Parent. Consequently,
the amount of goodwill allocated to Subsidiary A is HK$280,000 (i.e. HK$580,000 –
HK$300,000).
The table below sets out the testing of Subsidiary A for impairment:
Goodwill of Net identifiable Total
Subsidiary A assets
HK$ HK$ HK$
Carrying amount 280,000 2,500,000 2,780,000
Recoverable amount (2,600,000)
Impairment loss 180,000
Consistent with Section 14.5.3.1, the impairment loss of HK$180,000 is allocated to
the assets of Subsidiary A (the cash-generating unit) first by reducing the carrying amount
of goodwill.
Accordingly, the entire amount of the impairment loss for Subsidiary A (HK$180,000)
is allocated to the goodwill, reducing its carrying amount to HK$100,000. As mentioned
in Section 14.5.3.1, because partially owned Subsidiary A is a cash-generating unit, the
goodwill impairment loss is allocated to the controlling and non-controlling interests in
Subsidiary A on the same basis for which profit or loss is allocated. In this example, profit
or loss is allocated on the basis of the relative ownership interests (i.e. 90% to Parent and
10% to non-controlling interests).
Apply and Analyse 7 below encapsulates the allocation of corporate assets and goodwill
to cash-generating units and the allocation of impairment losses to cash-generating units, as
covered in Sections 14.5.3–14.5.5. It also illustrates the general requirements of the standard
for the timing of impairment testing, as covered in Section 14.2.
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FINANCIAL REPORTING
Apply and Analyse 7
FreshPak Limited (FreshPak) in the Opening Case is a large packaging company specialising
mainly in traditional food packaging products (such as cardboard, glass and plastic
packaging) and has a footwear division. In 20X0, FreshPak acquired a smaller listed
packaging company, Aurora Limited (Aurora). Aurora manufactures cardboard, glass and
plastic packaging products and has an innovative environmentally friendly packaging
division (‘EcoPak’) to cater to food manufacturing companies seeking environmentally
friendly packaging materials. EcoPak has a specialised research and development centre
(research centre) that has developed and patented a number of plant-based packaging
options in commercial use by Aurora. Aurora was acquired at a cost of HK$15 billion. The
research centre has been tasked with researching ways of updating the FreshPak’s more
traditional packaging products to protect its market share.
Aurora’s cardboard packaging plant is situated close to FreshPak’s cardboard
packaging plant. FreshPak expects to achieve significant savings by operating the plants as
one division.
The operations of FreshPak are conducted from a single headquarters. The
relative carrying amounts of the cash-generating units are a reasonable indication of
the proportion of the headquarters building devoted to each cash-generating unit.
The carrying amount of the research centre cannot be allocated on a reasonable and
consistent basis to the individual cash-generating units of FreshPak.
None of FreshPak’s assets is carried at a revalued amount. The following assumed facts
are an alternative scenario to that presented in respect of FreshPak in Apply and Analyse 1
in Section 14.3.4.2.
On 31 December 20X0, the carrying amounts of the assets of FreshPak within the
scope of HKAS 36 (including those of Aurora acquired through a business combination),
in HK$ billion, for each division (cash-generating unit) are listed below. In addition, the
amount of a rehabilitation liability integral to the determination of the recoverable amount
of the Plastics Division (i.e. the recoverable amount of the Plastics Division cannot be
determined without consideration of the rehabilitation liability because disposal of that
Division would require the buyer to assume that liability) is shown.
Assets and Cardboard Glass Plastics EcoPak Footwear Other Total
integral
liability
HK$ HK$ HK$ HK$ HK$ HK$ HK$
billion billion billion billion billion billion billion
Headquarters – – – – – 0.60 0.60
building
Research – – – – – 0.35 0.35
centre
Other 3.72 3.45 3.61 1.90 4.37 – 17.05
property,
plant and
equipment
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Im p a i r m ent o f Asset s
Apply and Analyse 7 (continued)
Assets and Cardboard Glass Plastics EcoPak Footwear Other Total
integral
liability
HK$ HK$ HK$ HK$ HK$ HK$ HK$
billion billion billion billion billion billion billion
Intangible – – – 1.35 – – 1.35
assets
(indefinite life)
Rehabilitation – – (1.25) – – – (1.25)
liability
Net recognised 3.72 3.45 2.36 3.25 4.37 0.95 18.10
assets
excluding
goodwill
Goodwill 0.55 – – – – – 0.55
Total net 4.27 3.45 2.36 3.25 4.37 0.95 18.65
recognised
assets
Goodwill has been allocated to the Cardboard Division, which includes the cardboard
packaging operations of FreshPak and Aurora.
The EcoPak Division (cash-generating unit) includes an acquired brand name, which is
classified as an indefinite life intangible asset.
Each depreciable asset is depreciated using the straight-line method. The useful life
of the headquarters building on 31 December 20X0 is 30 years. The weighted average
remaining useful lives of assets within each cash-generating unit, on 31 December 20X0
and 31 December 20X1, are as follows:
Remaining Card- Glass Plastics EcoPak Footwear Head- Research
useful life board quarters centre
(years) building
31 December 15 12 21 30 18 30 10
20X0
31 December 14 11 20 29 17 29 9
20X1
On 31 December 20X1, the carrying amounts of the assets of FreshPak within the
scope of HKAS 36 in HK$ billion, for each division (cash-generating unit), excluding the
effects of any impairment losses that might be recognised on 31 December 20X0, are:
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FINANCIAL REPORTING
Apply and Analyse 7 (continued)
Assets and Cardboard Glass Plastics EcoPak Footwear Other Total
integral
liability
HK$ HK$ HK$ HK$ HK$ HK$ HK$
billion billion billion billion billion billion billion
Headquarters – – – – – 0.58 0.58
building
Research – – – – – 0.315 0.315
centre
Other 3.47 3.16 3.44 2.05 4.13 – 16.25
property,
plant and
equipment
Intangible – – – 1.35 – – 1.35
assets
(indefinite
life)
Rehabilitation – – (1.32) – – – (1.32)
liability
Net 3.47 3.16 2.12 3.4 4.13 0.895 17.175
recognised
assets
excluding
goodwill
Goodwill 0.55 – – – – – 0.55
Total net 4.02 3.16 2.12 3.4 4.13 0.895 17.725
recognised
assets
There were no indications of impairment for any of FreshPak’s cash-generating units
on 31 December 20X0. Nevertheless, if the recoverable amount of the Cardboard Division
were formally estimated on that date, its recoverable amount would be found to be less
than its carrying amount.
In December 20X1, global market interest rates increased significantly, affecting
the borrowing costs and economic activity in each market in which each of FreshPak’s
divisions operates.
The recoverable amount of each cash-generating unit on 31 December 20X0 and
31 December 20X1, if such amount needed to be calculated, is set out below. On
31 December 20X0, for each cash-generating unit, the recoverable amount is represented
by value in use, which exceeds the sum of the fair values less costs of disposal of the
assets composing the cash-generating unit. On 31 December 20X1, the recoverable
amount is represented by value in use for each cash-generating unit other than the
Footwear Division for which the recoverable amount, if it were calculated, would be
measured as the sum of the fair values less costs of disposal of the assets composing the
cash-generating unit.
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Apply and Analyse 7 (continued)
Recoverable Cardboard Glass Plastics EcoPak Footwear
amount on:
HK$ billion HK$ billion HK$ billion HK$ billion HK$ billion
31 December 4.228 3.6667 2.5225 3.81 4.5745
20X0
31 December 3.513 2.956 2.034 3.60 4.055
20X1
Required:
For the reporting dates 31 December 20X0 and 31 December 20X1:
A. Apply the requirements of HKAS 36 for the timing of impairment testing to identify
the assets and cash-generating units of FreshPak that must tested for impairment;
B. Apply the criteria in HKAS 36 for allocating corporate assets to FreshPak’s
cash-generating units and calculate the amounts of corporate assets to be
allocated to the carrying amount of each cash-generating unit tested for
impairment. Justify your conclusions with your reasons;
C. Identify, and calculate the amounts of, any impairment losses for each of
FreshPak’s cash-generating units and demonstrate to which assets within the
cash-generating units any impairment loss is allocated;
D. Advise the management of FreshPak on how to allocate any impairment losses to
different cash-generating units, noting any areas of judgement required;
E. Integrate the outcomes of impairment testing at different levels of aggregation
within FreshPak; and
F. Where impairment losses are recognised:
(i) calculate their aggregate amount and demonstrate their treatment within
comprehensive income for the period; and
(ii) calculate the revised carrying amounts of each affected cash-generating unit
(and, where cash-generating units include more than one class of assets, each
class of assets within the cash-generating unit).
Analysis:
31 December 20X0
On 31 December 20X0, FreshPak tests for impairment only its Cardboard and EcoPak
Divisions (cash-generating units). There are no indications of impairment affecting any of
FreshPak’s divisions. However, HKAS 36 requires:
• The Cardboard Division to be tested annually for impairment because it includes
goodwill, which cannot be tested for impairment separately because it does
not generate cash inflows independently of the other assets in the Cardboard
Division; and
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Apply and Analyse 7 (continued)
• The EcoPak Division to be tested annually for impairment because it includes an
indefinite life intangible asset (an acquired brand name), the value in use of which
is generated jointly from operating with the other assets in the EcoPak Division.
To test these two cash-generating units for impairment, it is necessary to allocate any
corporate assets to them to determine their carrying amounts. This requires corporate
assets to be allocated to all of the cash-generating units they support to determine the
portions of their carrying amounts that should be allocated to the two cash-generating
units being tested for impairment.
FreshPak’s corporate assets are the headquarters building and the company’s research
centre. This is because those assets do not generate cash inflows independently of other
assets or Divisions of FreshPak and their carrying amount cannot be fully attributed to any
particular cash-generating asset under review.
Because the headquarters building can be allocated on a reasonable and consistent
basis to the cash-generating units under review, its carrying amount is allocated to the
carrying amount of each individual cash-generating unit.
However, the research centre’s assets cannot be allocated on a reasonable and
consistent basis to the cash-generating units under review. Consequently, FreshPak
identifies the smallest group of cash-generating units to which the carrying amount of the
centre’s assets can be allocated. That ‘smallest group of cash-generating units’ is FreshPak
as an entire entity. FreshPak compares the carrying amount of all assets, including the
research centre’s assets, with its recoverable amount.
The process of allocating the headquarters building’s carrying amount to the cash-
generating units is set out below. A weighted allocation basis is used because the
estimated remaining useful lives of the headquarters building and of the cash-generating
units’ property, plant and equipment differ. The carrying amounts of the cash-generating
units’ property, plant and equipment, weighted by their relative useful lives, provide the
best basis for estimating the respective services the headquarters building contributes to
each cash-generating unit.
Allocation of the headquarters building (allocable corporate asset):
Calculation Cardboard Glass Plastics EcoPak Footwear Total
of carrying
amount of cash-
generating units
after allocation
of headquarters
building
HK$ HK$ HK$ HK$ HK$ HK$
billion billion billion billion billion billion
(A) Carrying amount 3.72 3.45 3.61 1.90 4.37 17.05
of ‘non-corporate’
property, plant and
equipment
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Im p a i r m ent o f Asset s
Apply and Analyse 7 (continued)
Calculation Cardboard Glass Plastics EcoPak Footwear Total
of carrying
amount of cash-
generating units
after allocation
of headquarters
building
HK$ HK$ HK$ HK$ HK$ HK$
billion billion billion billion billion billion
Remaining useful life 15 12 21 30 18 –
Weighting based on 0.5 0.4 0.7 1.0 0.6 –
useful life (30 years)
Weighted carrying 1.86 1.38 2.527 1.90 2.622 10.289
amount
Pro-rata allocation of 18.08% 13.41% 24.56% 18.47% 25.48% 100.0%
headquarters building
(1.86 ÷ (1.38 ÷ (2.527 ÷ (1.90 ÷ (2.622 ÷
10.289) 10.289) 10.289) 10.289) 10.289)
(B) Allocation of the 0.1085 0.0805 0.1473 0.1108 0.1529 0.6
carrying amount of the
building (based on pro
rating)
(18.08% × (13.41% (24.56% (18.47% (25.48% ×
HK$0.6 bill) × × HK$0.6 × HK$0.6 bill)
HK$0.6 bill) HK$0.6
bill) bill)
(C) Other assets and 0.55 – (1.25) 1.35 – 0.65
liabilities
Carrying amount of 4.3785 3.5305 2.5073 3.3608 4.5229 18.3a
cash-generating unit
after allocation of
headquarters building
[= (A) + (B) + (C)]
a
Represents the carrying amount of the total recognised net assets within the scope of HKAS 36 (HK$18.65 billion)
minus the carrying amount of the unallocated corporate asset, i.e. the research centre (HK$350 million).
Impairment testing of cash-generating units after allocation of the headquarters building
(allocable corporate asset):
Cardboard EcoPak
HK$ billion HK$ billion
Carrying amount of cash-generating unit after 4.3785 3.3608
allocation of headquarters building
Recoverable amount (4.2280) (3.8100)
Impairment loss 0.1505 –
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FINANCIAL REPORTING
Apply and Analyse 7 (continued)
In accordance with HKAS 36, the impairment loss of HK$150.5 million recognised
with respect to FreshPak’s Cardboard Division for the year ending 31 December 20X0
is allocated first by reducing the carrying amount of goodwill. Because the balance
of goodwill before recognition of the impairment loss (HK$550 million) exceeds the
impairment loss, that loss is allocated entirely to the balance of goodwill. Consequently,
the revised carrying amount for the Cardboard Division’s goodwill on 31 December 20X0
is HK$399.5 million. The balance of Cardboard Division’s property, plant and equipment
remains unchanged as HK$3.72 billion, and the aggregate carrying amount of Cardboard
Division is revised to HK$4.1195 billion (i.e. HK$3.72 billion + HK$399.5 million). Similarly,
the carrying amount of the headquarters building allocated to the Cardboard Division for
the purpose of impairment testing (HK$108.5 million) remains unchanged. The revised
aggregate carrying amount of Cardboard Division (HK$4.1195 billion) and the unchanged
carrying amount of the headquarters building allocated to the Cardboard Division
(HK$108.5 million) sum to the recoverable amount of Cardboard Division on 31 December
20X0 (HK$4.228 billion).
The excess of EcoPak Division’s recoverable amount over its carrying amount is
HK$449.2 million (i.e. HK$3.81 billion – HK$3.3608 billion). Because this amount exceeds
the HK$350 million carrying amount of the unallocated corporate asset (the research
centre), testing the research centre for impairment is unnecessary because doing so would
have required testing the whole of FreshPak for impairment.
Accordingly, the only impairment loss recognised by FreshPak for the year ending
31 December 20X0 is the loss of HK$150.5 million with respect to the Cardboard Division
and allocated entirely to the goodwill in that Division. Because none of FreshPak’s assets
is carried at a revalued amount, the impairment loss of HK$150.5 million is recognised
immediately in profit or loss as a loss.
31 December 20X1
In late December 20X1, global market interest rates increased significantly, affecting the
borrowing costs and economic activity in each market in which each of FreshPak’s divisions
operates. HKAS 36 identifies an increase in market interest rates as an indication of
impairment. Therefore, FreshPak tests each of its cash-generating units for impairment on
31 December 20X1.
On 31 December 20X1, recoverable amount is represented by the value in use for each
cash-generating unit other than the Footwear Division (for which the recoverable amount
is measured as the sum of the fair values less costs of disposal of its component assets).
First step of impairment testing
Before testing the carrying amount of each division (cash-generating unit) for impairment,
FreshPak allocates the carrying amount of the headquarters building (HK$580 million) to
the cash-generating units.
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Apply and Analyse 7 (continued)
Allocation of the headquarters building (allocable corporate asset)
Calculation Cardboard Glass Plastics EcoPak Footwear Total
of carrying
amount of cash-
generating units
after allocation
of headquarters
building
HK$ HK$ HK$ HK$ HK$ HK$
billion billion billion billion billion billion
(A) Carrying amount 3.47 3.16 3.44 2.05 4.13 16.25
of ‘non-corporate’
property, plant and
equipment
Remaining useful life 14 11 20 29 17 –
Weighting based on 0.483 0.379 0.69 1.0 0.586 –
remaining useful life
(29 years)
Weighted carrying 1.675 1.199 2.372 2.05 2.421 9.717
amount
Pro-rata allocation of 17.24% 12.34% 24.41% 21.1% 24.91% 100.0%
headquarters building
(1.675 ÷ (1.199 ÷ (2.372 ÷ (2.05 ÷ (2.421 ÷
9.717) 9.717) 9.717) 9.717) 9.717)
(B) Allocation of the 0.1 0.0715 0.1416 0.1224 0.1445 0.58
carrying amount of the
building (based on pro
rating)
(17.24% × (12.34% (24.41% × (21.1% × (24.91% ×
HK$0.58 bill) × HK$0.58 HK$0.58 HK$0.58
HK$0.58 bill) bill) bill)
bill)
(C) Other assets and 0.3995 – (1.32) 1.35 – 0.4295
liabilities
Carrying amount of 3.9695 3.2315 2.2616 3.5224 4.2745 17.2595
cash-generating unit
after allocation of
headquarters building
[= (A) + (B) + (C)]
The headquarters building is included in the carrying amount of each cash-generating
unit to test whether any of those cash-generating units is impaired. FreshPak then
allocates any impairment losses determined on that basis between the headquarters
building and the other assets in each cash-generating unit because the headquarters
building is subsequently accounted for separately from the assets belonging wholly to each
cash-generating unit (e.g. depreciated, and independently allocated to the cash-generating
units in future impairment assessments).
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FINANCIAL REPORTING
Apply and Analyse 7 (continued)
Impairment testing of cash-generating units after allocation of the headquarters building
(allocable corporate asset):
Cardboard Glass Plastics EcoPak Footwear Total
HK$ HK$ HK$ HK$ HK$ HK$
billion billion billion billion billion billion
Carrying amount 3.9695 3.2315 2.2616 3.5224 4.2745 17.2595
of cash-generating
unit after allocation
of headquarters
building
Recoverable amount 3.513 2.956 2.034 3.60 4.055 16.158
Impairment loss (0.4565) (0.2755) (0.2276) – (0.2195) (1.1791)
Allocation of the impairment losses between assets of the cash-generating units and the
headquarters building
Cardboarda Glass Plastics Footwear Total
HK$ HK$ HK$ HK$ HK$
billion billion billion billion billion
Impairment
loss allocated to
headquarters
building:
Calculation (0.057 × (0.2755 × (0.2276 × (0.2195 ×
0.1/3.57) 0.0715/3.2315) 0.1416/2.2616) 0.1445/4.2745)
Resulting 0.0016 0.0061 0.0143 0.0074 0.0294
amount
Impairment
loss allocated to
other assets in
cash-generating
unit:
Calculation (0.3995 + (0.2755 × (0.2276 × (0.2195 ×
(0.057 × 3.16/3.2315) 2.12/2.2616) 4.13/4.2745)
3.47/3.57))
Resulting 0.4549 0.2694 0.2133 0.2121 1.1497
amount
Total 0.4565 0.2755 0.2276 0.2195 1.1791
impairment loss
a
First, the impairment loss for the Cardboard cash-generating unit (HK$456.5 million) is allocated to reduce
the carrying amount of goodwill allocated to that cash-generating unit (HK$399.5 million). Once that balance of
goodwill is fully written off, the remainder of the impairment loss for that cash-generating unit (HK$456.5 million –
HK$399.5 million, i.e. HK$57 million), is allocated pro rata between the carrying amounts of the headquarters
building (HK$100 million) and the other assets than goodwill in the cash-generating unit (HK$3.47 billion).
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Apply and Analyse 7 (continued)
Second step of impairment testing
Because the research centre cannot be allocated on a reasonable and consistent basis
to FreshPak’s cash-generating units, the carrying amount of the smallest group of cash-
generating units to which the carrying amount of the research centre can be allocated
(which is the whole of FreshPak) is compared with its recoverable amount.
Impairment testing the smallest group of cash-generating units to which the carrying amount of
the research centre can be allocated (the whole of FreshPak)
Card- Glass Plastics Eco-Pak Footwear Head- Research Total
board quarters centre
building
HK$ HK$ HK$ HK$ HK$ HK$ HK$ HK$
billion billion billion billion billion billion billion billion
Carrying 3.8695 3.16 2.12 3.4 4.13 0.58 0.315 17.5745
amount
Impairment (0.4549) (0.2694) (0.2133) – (0.2121) (0.0294) – (1.1791)
loss before
testing
research
centrea
Resulting 3.4146 2.8906 1.9067 3.4 3.9179 0.5506 0.315 16.3954
carrying
amount
Recoverable – – – – – – – 16.158
amount
Impairment – – – – – – – (0.2374)
loss for the
‘larger cash-
generating
unit’ (whole
entity)
a
Impairment loss in relation to carrying amounts of cash-generating units after allocation of corporate asset
(headquarters building)
Allocation of impairment loss for the larger cash-generating unit (whole entity)
Each cash-generating unit within the larger cash-generating unit (FreshPak) is treated as
an asset for the purpose of allocating the impairment loss for FreshPak on 31 December
20X1. With the goodwill in the Cardboard Division’s cash-generating unit having been
written off, the additional impairment loss identified only at the whole-of-entity level
(HK$237.4 million) is allocated to each asset pro rata on the basis of its carrying amount,
provided that the carrying amount of an asset is not reduced below the highest of its fair
value less costs of disposal and value in use.
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Apply and Analyse 7 (continued)
The recoverable amount of the assets composing the Footwear Division was calculated
as its fair value less costs of disposal (HK$4.055 billion), which exceeds the carrying amount
of that cash-generating unit (HK$3.9179 billion). Therefore, none of the impairment
loss identified only at the whole-of-entity level (HK$237.4 million) is allocated to the
Footwear Division.
This amount of the additional impairment loss identified at the whole-of-entity level
after including the research centre allocated to it is HK$64.7 million, based on EcoPak’s
carrying amount excluding a share of the headquarters building. This is calculated
as follows:
Impairment for the whole entity after including the carrying amount HK$237.4 million
of the research centre
×
EcoPak’s carrying amount excluding a share of the HK$3.4 billion
headquarters building
÷
The aggregate carrying amount (after recognising the impairment HK$12.4775 billion
loss identified at the level of each individual cash-generating unit)
of all cash-generating units other than the Footwear Division
(HK$16.3954 billion – HK$3.9179 billion)
Judgement is necessary in determining whether the EcoPak Division should have a
pro-rata share of the additional impairment loss identified at the whole-of-entity level after
including the research centre allocated to it. This is because:
• HKAS 36 specifies that allocating an impairment loss does not reduce the carrying
amount of an asset below its value in use (if determinable); and
• In contrast with all of the other cash-generating units with a recoverable amount
measured at value in use, EcoPak division has a value in use (HK$3.6 billion) that
exceeds its carrying amount (HK$3.5224 billion after allocating a share of the
headquarters building).
In fact, allocating the impairment loss identified at the whole-of-entity level must
involve reducing the carrying amount of some assets below their value in use because each
division other than the Footwear Division (the recoverable amount of which is measured
at fair value less costs of disposal) and the EcoPak Division was written down to its value in
use before testing the whole entity (including the research centre) for impairment.
What differentiates the EcoPak Division from other divisions is that if a pro-rata share
of the additional impairment loss identified at the whole-of-entity level (HK$64.7 million) is
added to the carrying amount of the EcoPak Division including a share of the headquarters
building (HK$3.5224 billion), that sum will still be less than the value in use of the EcoPak
Division (HK$3.6 billion). The margin between the EcoPak Division’s value in use and
carrying amount warrants excluding that division from the allocation of any portion of the
additional impairment loss identified at the whole-of-entity level.
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Apply and Analyse 7 (continued)
The need to exercise judgement in deciding whether to allocate to EcoPak Division any
portion of the additional impairment loss identified at the whole-of-entity level stems from
the inherently arbitrary nature of allocations of impairment losses with respect to some
corporate assets (that is, corporate assets with carrying amounts that cannot be allocated
on a reasonable and consistent basis to particular cash-generating units composing
the entity).
The additional impairment loss is allocated among the other cash-generating units with
a recoverable amount estimated as its value in use, and the headquarters building and
research centre.
After the recognition of impairment losses for each cash-generating unit, the aggregate
written-down carrying amount for all of Fresh-Pak’s assets within the scope of impairment
testing is HK$16.3954 billion. The aggregate carrying amount across which the additional
HK$237.4 million is allocated is calculated as HK$16.3954 billion – HK$3.9179 billion (the
carrying amount of the Footwear division) – HK$3.4 billion (the carrying amount of the
EcoPak division) = HK$9.0775 billion.
Cardboard* Glass Plastics Headquarters Research
Building Centre
HK$ billion HK$ billion HK$ billion HK$ billion HK$ billion
Carrying 3.4146 2.8906 1.9067 0.5506 0.315
amount after
recognition of
impairment
losses (first
step)
Impairment
loss allocated:
Calculation 0.2374 × 0.2374 × 0.2374 × 0.2374 × 0.2374 ×
3.4146/9.0775 2.8906/9.0775 1.9067/9.0775 0.5506/9.0775 0.315/9.0775
Resulting (0.089) (0.076) (0.050) (0.014) (0.008)
allocation
Resulting 3.3256 2.8146 1.8567 0.5366 0.307
carrying
amount
(second step)
The total amount of impairment losses recognised by FreshPak for the year
ended 31 December 20X1 is HK$1.4165 billion, i.e. HK$1.1791 billion (for first step) +
HK$237.4 million (for second step). Because none of FreshPak’s assets is carried at a
revalued amount, the impairment loss of HK$1.4165 billion is recognised immediately in
profit or loss as an expense.
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FINANCIAL REPORTING
Apply and Analyse 7 (continued)
On 31 December 20X1, the carrying amounts of the assets of FreshPak after
recognising the impairment losses are:
Cardboard Glass Plastics EcoPak Footwear Other Total
HK$ HK$ HK$ HK$ HK$ HK$ HK$
billion billion billion billion billion billion billion
Headquarters – – – – – 0.5366 0.5366
building
Research – – – – – 0.3070 0.3070
centre
Other 3.3256 2.8146 3.1767 1.9853 3.9179 – 15.2201
property,
plant and
equipment
Intangible – – – 1.35 – – 1.35
assets
(indefinite life)
Rehabilitation – – (1.32) – – – (1.32)
liability
Net 3.3256 2.8146 1.8567 3.3353 3.9179 0.8436 16.0937
recognised
assets
excluding
goodwill
Goodwill – – – – – – –
Total net 3.3256 2.8146 1.8567 3.3353 3.9179 0.8436 16.0937
recognised
assets
Key Learning Point
When a cash-generating unit is tested for impairment, all of the assets used to generate
the unit’s cash flows (including a portion of goodwill and corporate assets that can be
allocated to the unit on a reasonable and consistent basis) are included in the aggregate
carrying amount compared with the unit’s recoverable amount.
Any impairment loss for the cash-generating unit is allocated first to goodwill, with
any remainder pro rated to the carrying amounts of the other assets (subject to some
constraints).
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Knowledge Check Questions
Question 11
Pleats Limited (Pleats) grows cotton and uses that cotton to manufacture fabric used in the
clothing industry (in one factory). All of the grown cotton is used internally as an input to
the manufacture of cotton fabric. An active market exists for the company’s grown cotton.
Determine how many cash-generating units Pleats has in relation to its cotton production
and processing operations, and justify your conclusion with reasoning.
Question 12
Jam Pty Limited (Jam) has two cash-generating units. Cash-generating unit A had
a carrying amount of HK$700 million and recoverable amount of HK$750 million.
Cash-generating unit B has a carrying amount of HK$900 million and a recoverable amount
of HK$800 million. The carrying amount of the head office assets is HK$400 million.
Cash-generating units A and B utilise the head office equally. The impairment loss for
cash-generating unit A is:
A HK$0
B HK$50 million
C HK$150 million
D HK$350 million
Question 13
A cost-generating unit with a carrying amount of HK$750 million is considered to be
impaired. The value in use of the cash-generating unit is calculated as HK$630 million. The
fair value less costs of disposal for each class of assets forming the cash-generating unit is
calculated as HK$575 million. The carrying amount and fair value less costs of disposal for
each class of assets composing the cash-generating unit are set out in the table below:
Class of assets Carrying amount Fair value less
costs of disposal
HK$m HK$m
Buildings 200 190
Plant and equipment 400 310
Licence 100 75
Goodwill 50 –
Total 750 575
Solve which of the following carrying amounts of plant and equipment after allocating
the impairment loss to each relevant class of assets is consistent with applying HKAS 36,
and demonstrate your calculations:
A HK$310 million
B HK$336 million
C HK$352 million
D HK$360 million
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FINANCIAL REPORTING
Knowledge Check Questions (continued)
Question 14
Assume that the fact pattern in Knowledge Check Question 13 is amended in just
one respect: After completing the process of allocating the impairment loss for the
cash-generating unit (based on the value in use of that unit) to each class of assets,
an unallocable amount of HK$10 million remains. This is because, under the changed
information, fully allocating the impairment loss would require at least one class of assets
to be written below its fair value less costs of disposal. What would be the carrying amount
of the cash-generating unit after recognising the impairment loss in accordance with
HKAS 36? Justify your conclusion with reasoning.
Question 15
Alpha Centauri Limited (Alpha Centauri) acquires Polaris Limited (Polaris) in a business
combination on 31 May 20X8. Three of Alpha Centauri’s eight cash-generating units
(Units A, C and E) are expected to benefit from the synergies of the business combination.
The only acquired goodwill recognised as an asset by Alpha Centauri on 31 December 20X8
is the goodwill acquired in the acquisition of Polaris.
Cash-generating unit B includes an intangible asset with an indefinite useful life
acquired on 1 April 20X8. Cash-generating unit D includes an intangible asset not yet
available for use and was acquired on 30 November 20X8. Alpha Centauri’s other cash-
generating units are named F, G and H.
Apply the requirements of HKAS 36 to identify when impairment testing of the assets
and/or cash-generating units of Alpha Centauri must be conducted. Identify whether and in
what manner your answer would change if Alpha Centauri is unable, by 31 December 20X8,
to complete the initial allocation of the goodwill acquired in the business combination to
the cash-generating units expected to benefit from the synergies of the combination.
1 4 . 6 REVERSING AN IMPAIRMENT LOSS
14.6.1 Reversing an Impairment Loss
Wherever an impairment of assets has been recognised, management must consider whether
impairment loss needs to be reversed.
14.6.1.1 External Sources of Information
External sources of information, which are to be considered when assessing if anything shows
that an impairment loss recognised in prior periods for an asset other than goodwill no longer
exists or has decreased, include but are not limited to the following:
• External public evidence shows that the asset’s value has increased significantly during
the period;
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• Favourable technological, market, economic, or legal changes have occurred or are
expected to occur in the environment in which the entity operates or in the market in
which the asset operates; and
• Favourable changes to interest rates or other inputs used to determine the discount
rate (e.g. inputs to weighted average cost of capital), which would lead to lower discount
HKAS
rate used in calculating the asset’s value in use and result in a significant increase to the
36.111(a)–(c) asset’s recoverable amount.
14.6.1.2 Internal Sources of Information
Internal sources of information, which are to be considered when assessing if anything shows
that an impairment loss recognised in prior periods for an asset (other than goodwill) no longer
exists or has decreased, include but are not limited to the following:
• The asset has been improved or enhanced in a way that is expected to increase cash
inflows or reduce cash outflows in future periods;
• Major inputs have reduced in price due to renegotiations of contracts resulting in an
improvement in net cash flows; and
HKAS
• New customers or markets have been negotiated resulting in an increase in
36.111(d)–(e) cash inflows.
14.6.2 Reversing an Impairment Loss for an Individual Asset (LO8)
If anything indicates that an impairment loss recognised previously no longer exists or has
decreased, an impairment test will be required to be performed following the same process as
that described in Sections 14.3 and 14.4. The resulting recoverable amount is compared with
the carrying value of the asset.
If there has been a change in estimates used to determine the asset’s recoverable amount
and the recoverable amount is greater than the carrying amount, the previous impairment loss
will be reversed. The extent by which the impairment loss is reversed is the difference between
the carrying amount and the lower of:
• The recoverable amount; and
HKAS • The carrying amount, net of amortisation or depreciation, that would have been
36.117 determined had no impairment loss previously been recognised.
Illustrative Example 5
The following example uses the amounts for the headquarters building in Apply and Analyse
7 in Section 14.5.5.2 but, for simplicity, assumes the building is tested for impairment and
reversals of impairment as a stand-alone asset instead of being a corporate asset.
The headquarters building of FreshPak is measured on the cost model subsequent
to initial recognition. On 31 December 20X0, the building has a carrying amount of
HK$600,000,000 and a remaining useful life of 30 years. Its depreciation expense,
calculated using the straight-line method, is HK$20,000,000 per annum.
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FINANCIAL REPORTING
Illustrative Example 5 (continued)
On 31 December 20X1, the building has a carrying amount of HK$580,000,000 but an
impairment loss of HK$36,400,000 for the building is identified and recognised on that
date. Consequently:
• The building’s carrying amount (incorporating the impairment loss) on
31 December 20X1 is HK$543,600,000; and
• The depreciation expense for the year ending 31 December 20X2, based on the
building’s impaired carrying amount, is calculated as HK$543,600,000 ÷ 29 years
(remaining useful life) = HK$18,744,828. The building’s carrying amount on 31
December 20X2, based on those calculations, is HK$543,600,000 – HK$18,744,828 =
HK$524,855,172.
During the year ended 31 December 20X2, global market interest rates significantly
decreases, affecting the borrowing costs and economic activity in each market in which
FreshPak recovers the carrying amount of its headquarters building. This favourable
change in FreshPak’s environment changes the estimates used to determine the
building’s recoverable amount since the impairment loss is recognised. Consequently,
it obliges FreshPak to re-estimate the recoverable amount of its headquarters building
on 31 December 20X2. FreshPak estimates the recoverable amount of the building on
31 December 20X2 as HK$565 million.
Consequently, the impairment loss on the headquarters building is reversed but only
to the extent that the resulting revised carrying amount does not exceed the amount at
which the building would have been carried, on the cost model, on 31 December 20X2,
had the impairment loss not been recognised on 31 December 20X1. That is, the carrying
amount must not exceed the asset’s pre-impairment carrying amount − depreciation
because the impairment date that would have been charged without the impairment
HK$580,000,000 HK$20,000,000 HK$560,000,000
Therefore, the building’s carrying amount is revised to HK$560 million, not to the
recoverable amount of HK$565 million. The amount of the reversal of the impairment loss
recognised in profit or loss on 31 December 20X2 is HK$560,000,000 − HK$524,855,172,
i.e. HK$35,144,828.
A reversal of an impairment loss for an asset (other than goodwill) is required to be
recognised immediately in profit or loss unless the asset is carried at a revalued amount in
accordance with another standard (for example, the revaluation model in HKAS 16
Property, Plant and Equipment or HKAS 38 Intangible Assets ) in which case the reversal might
HKAS qualify to be recognised as an increase in the revaluation reserve in other comprehensive
36.119 income.
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In Illustrative Example 5 above, the reversal of the impairment loss (HK$35,144,828) is
recognised immediately in profit or loss because the headquarters building of FreshPak
is carried on the cost model. The accounting entry to recognise the reversal of the
impairment loss is:
On 31 December 20X2
Debit Credit
HK$ HK$
Accumulated impairment - Headquarters building 35,144,828
Reversal of impairment loss (profit or loss) 35,144,828
(Reversal of impairment loss)
If previous impairments on a revalued asset had used the entire balance of the revaluation
HKAS reserve and an amount was recognised in profit and loss, the amount recognised in profit and
36.120 loss would be reversed before any surplus is recognised in the revaluation reserve.
HKAS The reversal of an impairment loss should trigger a review of the useful life, deprecation
36.121 method and other depreciation assumptions.
14.6.3 Reversing an Impairment Loss for a Cash-generating Unit
A reversal of an impairment loss for a cash-generating unit is allocated to the assets of the unit,
except for goodwill, on a pro-rata basis consistent with the carrying values of the assets within
the cash-generating unit. A reversal of an impairment loss for a cash-generating unit
(other than goodwill) is recognised immediately in profit or loss unless the assets in the
cash-generating unit are carried at revalued amount in accordance with another standard
HKAS (for example, the revaluation model in HKAS 16 or HKAS 38) in which case the reversal is
36.122 recognised as an increase in the revaluation reserve in other comprehensive income.
As with the recognition of an impairment reversal for individual assets, when allocating a
reversal of an impairment loss for a cash-generating unit in accordance, the carrying amount of
any asset in the cash-generating unit is not increased above the lower of its recoverable
amount (if determinable) and the carrying amount that would have been determined (net of
HKAS amortisation or depreciation) had no impairment loss been recognised for the asset in
36.123 prior periods.
14.6.4 Reversing an Impairment Loss for Goodwill
HKAS
36.124 Impairment losses previously recognised for goodwill cannot be reversed.
Any increase in the recoverable amount of goodwill in the periods following the recognition
of an impairment loss for that goodwill is most likely to be an increase in internally generated
goodwill rather than a reversal of the impairment loss recognised for the acquired goodwill.
HKAS Because HKAS 38 prohibits the recognition of internally generated goodwill, there will be no
36.125 accounting required if this situation arises.
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FINANCIAL REPORTING
Apply and Analyse 8
This Apply and Analyse continues Apply and Analyse 7 in Section 14.5.5.2 with respect to the
following year (the year ended 31 December 20X2).
The balances of assets and liabilities on 31 December 20X1 in Apply and Analyse 7 are
the opening balances of assets and liabilities for the year ended 31 December 20X2. The
assumed facts for FreshPak Limited (FreshPak) are unchanged except for the following
assumptions regarding the events of the year ended 31 December 20X2:
• The research centre is disposed of (simplifying assumption);
• No purchases or other disposals of assets within the scope of HKAS 36 occurs;
• No change occurs to the carrying amount of the rehabilitation liability that is an
integral part of the Plastics Division’s cash-generating unit; and
• No change occurs to the carrying amount of the acquired brand name (indefinite
life intangible asset) that is part of the EcoPak cash-generating unit.
During the year ended 31 December 20X2, global market interest rates significantly
decreases, affecting the borrowing costs and economic activity in each market in which
FreshPak’s divisions operates. Consequently, the recoverable amount of all of FreshPak’s
divisions increases to HK$15.6 billion on 31 December 20X2.
Required:
For the reporting date 31 December 20X2:
A. Apply the requirements of HKAS 36 to identify which cash-generating units of
FreshPak must be tested for reversal of impairment;
B. Advise the management of FreshPak how to calculate the amount of any reversal
of impairment losses for the tested cash-generating unit of FreshPak and how
to allocate the reversal of impairment loss to the different cash-generating units
of FreshPak;
C. Where reversals of impairment losses are recognised:
• Calculate their aggregate amount and demonstrate their treatment within
comprehensive income for the period; and
• Calculate the revised carrying amounts of each affected cash-generating unit
(and, where cash-generating units include more than one class of assets, each
class of assets within the cash-generating unit); and
D. Solve how the treatment would change if the recoverable amount of FreshPak
changed to HK$16.5 billion and not HK$15.6 billion as stipulated above (on
31 December 20X2) and justify your conclusions.
796
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Im p a i r m ent o f Asset s
Apply and Analyse 8 (continued)
Analysis:
The significant decrease in global market interest rates during the year has affected
each of FreshPak’s divisions (cash-generating units). HKAS 36 identifies such an event
as an indication an impairment loss recognised in a prior period for an asset other than
goodwill may no longer exist or may have decreased. Such an event changes the estimates
used to determine recoverable amount because the impairment loss was recognised.
Consequently, FreshPak is required to estimate the recoverable amount of all its
cash-generating units.
First step of impairment reversal testing
The first step of impairment reversal testing for FreshPak is to allocate any corporate
assets to the carrying amounts of the cash-generating units.
Consistent with the analysis of Apply and Analyse 7 in Section 14.5.5.2, the
headquarters building is a corporate asset that can be allocated on a reasonable and
consistent basis to the cash-generating units under review, and its carrying amount
is allocated to the carrying amount of each individual cash-generating unit. This is
performed using the weighted-allocation methodology explained in Apply and Analyse 7
in Section 14.5.5.2 as shown below. The carrying amount of the headquarters building
and the amounts of the assets in each cash-generating unit include the calculation of
depreciation for the year ended 31 December 20X2, based on the post-impairment
carrying amounts determined on 1 January 20X2.
Allocation of headquarters building to cash-generating units (actual amounts for 20X2)
Calculation Card- Glass Plastics EcoPak Footwear Total
of carrying board
amount of cash-
generating units
after allocation
of headquarters
building
HK$ HK$ HK$ HK$ HK$ HK$
billion billion billion billion billion billion
Carrying amount 3.3256 2.8146 3.1767 1.9853 3.9179
of ‘non-corporate’
property, plant
and equipment
on 31 December
20X1 (including
impairment loss)
Remaining useful 14 11 20 29 17
life on 1 January
20X2 (years)
797
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FINANCIAL REPORTING
Apply and Analyse 8 (continued)
Calculation Card- Glass Plastics EcoPak Footwear Total
of carrying board
amount of cash-
generating units
after allocation
of headquarters
building
HK$ HK$ HK$ HK$ HK$ HK$
billion billion billion billion billion billion
Depreciation for 0.2375 0.2559 0.1588 0.0685 0.2305
20X2 based on
impaired amount
Calculation (3.3256 ÷ (2.8146 ÷ (3.1767 ÷ (1.9853 ÷ (3.9179 ÷
14) 11) 20) 29) 17)
(A) Carrying 3.0881 2.5587 3.0179 1.9168 3.6874 14.2689
amount of
‘non-corporate’
property, plant and
equipment on 31
December 20X2
Remaining 13 10 19 28 16
useful life on 31
December 20X2
(years)
Weighting based on 0.4643 0.3571 0.6786 1.0 0.5714
remaining useful
life of headquarters
building on 31
December 20X2 (28
years)
Weighted carrying 1.4338 0.9137 2.0479 1.9168 2.1071 8.4193
amount
Pro-rata allocation 17.03% 10.85% 24.3% 22.77% 25.03% 100.0%
of headquarters
building
(1.4338 ÷ (0.9137 ÷ (2.0479 ÷ (1.9168 ÷ (2.1071 ÷
8.4193) 8.4193) 8.4193) 8.4193) 8.4193)
(B) Allocation of the 0.0882 0.0562 0.1260 0.1180 0.1297 0.5181
carrying amount of
the building (based
on prorating)
(Building carrying (17.03% × (10.85% × (24.3% × (22.77% × (25.03% ×
amount = 0.5436 − HK$0.5181 HK$0.5181 HK$0.5181 HK$0.5181 HK$0.5181
(0.5436 ÷ 29)) bill) bill) bill) bill) bill)
798
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Im p a i r m ent o f Asset s
Apply and Analyse 8 (continued)
Calculation Card- Glass Plastics EcoPak Footwear Total
of carrying board
amount of cash-
generating units
after allocation
of headquarters
building
HK$ HK$ HK$ HK$ HK$ HK$
billion billion billion billion billion billion
(C) Other assets – – (1.32) 1.35 – 0.03
and liabilities
Carrying amount 3.1762 2.6149 1.8239 3.3848 3.8171 14.817
of cash-generating
unit after allocation
of headquarters
building
[= (A) + (B) + (C)]
Second step of impairment reversal testing
The second step of impairment reversal testing for FreshPak is to identify whether the
recoverable amount of FreshPak has increased to an amount in excess of the carrying
amount of its assets on the reporting date of 31 December 20X2.
The recoverable amount of all of FreshPak’s divisions on 31 December 20X2 is
HK$15.6 billion, which exceeded the aggregate carrying amount of FreshPak’s assets
within the scope of HKAS 36 on that date. (This aggregate comparison could be performed
without allocating the headquarters building to the cash-generating units, but is ordered in
this manner to show the depreciation calculations for the year ended 31 December 20X2.)
This is a prima facie indication that at least part of the impairment loss recognised on
31 December 20X1 has reversed.
Third step of impairment reversal accounting
The process of impairment reversal has moved from testing to accounting. The third step
of impairment reversal testing and accounting for FreshPak is to apply the ceiling test
imposed by HKAS 36 on the post-reversal carrying amounts of affected cash-generating
units. To determine the amount of any reversal of FreshPak’s impairment loss, it is
necessary to calculate the aggregate carrying amount of the cash-generating units that
would have been recognised on 31 December 20X2 had the impairment loss not been
recognised on 31 December 20X1. This ‘hypothetical’ calculation is performed to apply the
requirement in HKAS 36 that an impairment loss is only reversed to the extent that the
revised carrying amount for each asset does not exceed the carrying amount that would
have been determined (net of depreciation) had no impairment loss been recognised for
the asset in prior years (see table below).
799
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FINANCIAL REPORTING
Apply and Analyse 8 (continued)
The hypothetical calculation is not performed in relation to the impairment loss
recognised on 31 December 20X0 because the only asset with respect to which an
impairment loss is recognised on that date is goodwill. HKAS 36 does not permit reversals
of impairments of goodwill. Therefore, only calculating the hypothetical carrying amounts
for assets other than goodwill is necessary.
Allocation of headquarters building to cash-generating units (hypothetical amounts for 20X2)
Calculation Card- Glass Plastics EcoPak Footwear Total
of carrying board
amount of cash-
generating units
after allocation
of headquarters
building
HK$ HK$ HK$ HK$ HK$ HK$
billion billion billion billion billion billion
Carrying amount 3.47 3.16 3.44 2.05 4.13
of ‘non-corporate’
property, plant and
equipment on 31
December 20X1
before impairment
recognised
Remaining useful life 14 11 20 29 17
on 1 January 20X2
(years)
Depreciation for 0.2479 0.2873 0.172 0.0707 0.2429
20X2 based on
pre-impairment
carrying amount
Calculation (3.47 ÷ 14) (3.16 ÷ 11) (3.44 ÷ 20) (2.05 ÷ 29) (4.13 ÷ 17)
(A) Carrying amount 3.2221 2.8727 3.268 1.9793 3.8871 15.2292
of ‘non-corporate’
property, plant
and equipment on
31 December 20X2
Remaining useful life 13 10 19 28 16
on 31 December 20X2
(years)
Weighting based on 0.4643 0.3571 0.6786 1.0 0.5714
remaining useful
life of headquarters
building on 31
December 20X2
(28 years)
800
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Im p a i r m ent o f Asset s
Apply and Analyse 8 (continued)
Calculation Card- Glass Plastics EcoPak Footwear Total
of carrying board
amount of cash-
generating units
after allocation
of headquarters
building
HK$ HK$ HK$ HK$ HK$ HK$
billion billion billion billion billion billion
Weighted carrying 1.496 1.026 2.2176 1.9793 2.2212 8.9401
amount
Pro-rata allocation of 16.73% 11.48% 24.8% 22.14% 24.85% 100.0%
headquarters building
(1.496 ÷ (1.026 ÷ (2.2176 ÷ (1.9793 ÷ (2.2212 ÷
8.9401) 8.9401) 8.9401) 8.9401) 8.9401)
(B) Allocation of the 0.0937 0.0643 0.1389 0.124 0.1391 0.56
carrying amount of
the building (based on
prorating)
(Building carrying (16.73% × (11.48% × (24.8% × (22.14% × (24.85% ×
amount = 0.58 − HK$0.56 HK$0.56 HK$0.56 HK$0.56 HK$0.56
(0.58 ÷ 29)) bill) bill) bill) bill) bill)
(C) Other assets and – – (1.32) 1.35 – 0.03
liabilities
Carrying amount of 3.3158 2.937 2.0869 3.4533 4.0262 15.8192
cash-generating unit
after allocation of
headquarters building
[= (A) + (B) + (C)]
As calculated in the table above, the aggregate carrying amount of FreshPak’s
cash-generating units that would have been recognised on 31 December 20X2 had the
impairment loss not been recognised on 31 December 20X1 is HK$15.8192 billion.
Therefore, the amount of the reversal of impairment loss, in aggregate for FreshPak, is
the lesser of:
A. The excess of recoverable amount (HK$15.6 billion) over the aggregate pre-reversal
carrying amount of FreshPak’s cash-generating units (HK$14.817 billion), i.e.
HK$783 million; and
B. The excess of the aggregate carrying amount of FreshPak’s cash-generating units
that would have been recognised on 31 December 20X2 had the impairment loss
not been recognised on 31 December 20X1 (HK$15.8192 billion) over the aggregate
pre-reversal carrying amount (HK$14.817 billion), i.e. HK$1.002 billion.
801
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FINANCIAL REPORTING
Apply and Analyse 8 (continued)
Therefore, the amount of the reversal of impairment loss, in aggregate for FreshPak, is
HK$783 million. Because FreshPak measures its assets within the scope of HKAS 36 using
the cost model, the HK$783 million reversal of impairment loss is recognised immediately
in profit or loss as an item of income.
Fourth step of impairment reversal accounting
The fourth step of impairment reversal testing and accounting for FreshPak is to allocate
the HK$783 million reversal of the impairment loss to each cash-generating unit of
FreshPak pro rata with the carrying amounts of those cash-generating units.
Each cash-generating unit within the larger cash-generating unit (FreshPak) is treated
as an asset for the purpose of allocating the reversal of impairment loss for FreshPak on
31 December 20X2. The requirements of HKAS 36 for reversing an impairment loss apply
equally to an individual asset or a cash-generating unit.
The EcoPak Division is excluded from the allocation of the aggregate reversal of the
impairment loss for FreshPak because an impairment loss was not recognised in respect
of the EcoPak Division on 31 December 20X1. In addition, allocating any amount of that
aggregate reversal for FreshPak to the EcoPak Division would breach the requirement
in HKAS 36 that a reversal of an impairment loss must not result in the carrying amount
of an asset exceeding the carrying amount that would have been determined had no
impairment loss been recognised for the asset in prior years.
However, the EcoPak Division is included in the allocation of the headquarters building
to each cash-generating unit to which it provides services for the following reasons:
• It is necessary to determine the carrying amount of each cash-generating unit to
which a share of the reversal of the impairment loss is allocated. The allocation of
part of the carrying amount of the headquarters building to the EcoPak Division
affects the amount allocated to each other cash-generating unit; and
• A share of the headquarters building is not identified as impaired on 31 December
20X1 because it was part of the (fully recoverable) EcoPak Division. It would
therefore be inappropriate for that part of the headquarters building to be
allocated a gain on reversal of the impairment loss.
Allocating the pro-rata share of the HK$783 million reversal of the impairment loss
to each cash-generating unit of FreshPak (other than the EcoPak Division) involves an
iterative process. This is because, for some cash-generating units, adding the pro rata
share would result in a carrying amount exceeding the amount at which the individual
cash-generating unit would have been carried on 31 December 20X2 had no impairment
loss previously been recognised. The unallocable amounts are reallocated pro rata to the
other cash-generating units. This is shown in the table below.
802
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Im p a i r m ent o f Asset s
Apply and Analyse 8 (continued)
Allocation of reversal of impairment loss to cash-generating units (including allocated carrying
amount of headquarters building)
Steps in allocation Cardboard Glass Plastics Footwear Total
of reversal of
impairment loss
HK$ HK$ HK$ HK$ HK$
billion billion billion billion billion
Carrying amount of 3.1762 2.6149 1.8239 3.8171 11.4321
cash-generating unit after
allocation of headquarters
building
Tentative allocation of 0.2175 0.1791 0.1249 0.2615 0.783
reversal of impairment
loss (first round)
Calculation (3.1762 ÷ (2.6149 ÷ (1.8239 ÷ (3.8171 ÷
11.4321) × 11.4321) × 11.4321) × 11.4321) ×
0.783 0.783 0.783 0.783
Resulting tentatively 3.3937 2.794 1.9488 4.0786 12.2151
revised carrying amount
Carrying amount if no 3.3158 2.937 2.0869 4.0262
previous impairment loss
Revised carrying amount, 3.3158 2.794 1.9488 4.0262
subject to reallocations
Impairment loss unable to 0.0779 – – 0.0524 0.1303
be fully reversed
Tentative reallocation of – 0.0768 0.0535 – 0.1303
reversal of impairment
loss (second round)
Calculation (2.794 ÷ (1.9488 ÷
4.7428a) × 4.7428) ×
0.1303 0.1303
Resulting tentatively – 2.8708 2.0023 –
revised carrying amount
Resulting revised carrying 3.3158 2.8708 2.0023 4.0262 12.2151
amount
Total reversal of 0.1396 0.2559 0.1784 0.2091 0.783
impairment loss
a
HK$2.794 billion + HK$1.9488 billion = HK$4.7428 billion.
Fifth step of impairment reversal accounting
The fifth step of impairment reversal testing and accounting for FreshPak is to allocate the
HK$783 million reversal of the impairment loss between the assets of the cash-generating
units and the headquarters building. This calculation is shown in the table below.
803
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FINANCIAL REPORTING
Apply and Analyse 8 (continued)
Allocation of reversal of the impairment loss between assets of the cash-generating units and the
headquarters building
Distinguishing the Cardboard* Glass Plastics Footwear Total
reversal attributed to the
headquarters building
and the other assets
HK$ HK$ HK$ HK$ HK$
billion billion billion billion billion
Impairment reversal allocated
to headquarters building:
Calculation 0.1396 × 0.2559 × 0.1784 × 0.2091 ×
(0.0883 ÷ (0.0562 ÷ (0.1260 ÷ (0.1297 ÷
3.1762) 2.6149) 1.8239) 3.8171)
Resulting amount 0.0039 0.0055 0.0123 0.0071 0.0288
Impairment reversal
allocated to other assets in
cash-generating unit:
Calculation 0.1396 × (3.088 0.2559 × 0.1784 × 0.2091 ×
÷ 3.1762) (2.5587 ÷ (1.6979 ÷ (3.6874 ÷
2.6149) 1.8239) 3.8171)
Resulting amount 0.1357 0.2504 0.1661 0.202 0.754
Total reversal of impairment 0.1396 0.2559 0.1784 0.2091 0.783
loss
Based on the allocations above, on 31 December 20X2, the carrying amounts of the
assets of FreshPak after recognising the reversal of the impairment loss are set out in the
table below.
Post-reversal carrying amounts of the assets of FreshPak
Assets and Cardboard Glass Plastics EcoPak Footwear Other Total
liabilities
HK$ HK$ HK$ HK$ HK$ HK$ HK$
billion billion billion billion billion billion billion
Headquarters – – – – – 0.5888 0.5888
building
Other 3.224 2.8091 3.184 1.9168 3.8894 – 15.0233
property,
plant and
equipment
804
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Im p a i r m ent o f Asset s
Apply and Analyse 8 (continued)
Assets and Cardboard Glass Plastics EcoPak Footwear Other Total
liabilities
HK$ HK$ HK$ HK$ HK$ HK$ HK$
billion billion billion billion billion billion billion
Intangible – – – 1.35 – – 1.35
assets
(indefinite
life)
Rehabilitation – – (1.32) – – – (1.32)
liability
Net 3.224 2.8091 1.864 3.2668 3.8894 0.588 15.6421
recognised
assets
Alternative assumption about the recoverable amount of FreshPak
If the recoverable amount of FreshPak changes to HK$16.5 billion on 31 December 20X2,
the aggregate reversal of impairment loss recognised for FreshPak will be calculated as the
lesser of:
A. The excess of recoverable amount (HK$16.5 billion) over the aggregate pre-reversal
carrying amount of FreshPak’s cash-generating units (HK$14.817 billion), i.e.
HK$1.683 billion; and
B. The excess of the aggregate carrying amount of FreshPak’s cash-generating units
that would have been recognised on 31 December 20X2 had the impairment loss
not been recognised on 31 December 20X1 (HK$15.8192 billion) over the aggregate
pre-reversal carrying amount (HK$14.817 billion), i.e. HK$1.0022 billion.
Therefore, the aggregate reversal of impairment loss recognised for FreshPak would
be calculated as HK$1.0022 billion. Recognising a reversal of impairment loss in excess
of HK$1.0022 billion would be tantamount to reversing part or all of the impairment
losses of goodwill previously recognised in 20X0 and 20X1. HKAS 36 prohibits reversals of
impairment losses recognised in respect of goodwill.
Key Learning Point
The carrying amount of each asset cannot, as a result of reversing a impairment loss,
exceed its carrying amount (net of accumulated depreciation or amortisation) on the date
of reversal had no impairment loss previously been recognised.
805
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FINANCIAL REPORTING
Knowledge Check Question
Question 16
On 1 January 20X0, Skillsure Limited (Skillsure) acquires an item of equipment for a cost
of HK$20 million. The item, which is measured under the cost model, has a 10-year useful
life and a residual value of zero and is depreciated using the straight-line method. On
31 December 20X2, upon testing for impairment, the item is found to have suffered an
impairment loss. Its recoverable amount on that date is HK$10.5 million (its value in use),
and the item’s carrying amount is revised to that amount. There has been no change in the
remaining useful life of the equipment.
On 31 December 20X4, the carrying amount of the item of equipment is HK$7.5 million.
Upon testing for a possible reversal of impairment, the item’s recoverable amount
is calculated on that date as HK$11.0 million (its value in use). Because the revised
recoverable amount is based on changed estimates and is not simply the result of the
‘unwinding of the discount’ in the item’s value in use, Skillsure recognises a reversal of an
impairment loss in accordance with HKAS 36.
Solve which of the following amounts is the revised carrying amount of the item on 31
December 20X4 upon recognising the reversal of the impairment loss in accordance with
HKAS 36, and demonstrate your calculation:
A HK$14.0 million
B HK$11.0 million
C HK$10.5 million
D HK$10.0 million
1 4 . 7 DISCLOSURE OF AN IMPAIRMENT
HKAS 36 includes extensive disclosure requirements when an impairment loss has been
recognised by an entity.
When an impairment is recognised by an entity, HKAS 36 requires disclosure, by a class of
assets (i.e. a grouping of assets of a similar nature and use in the entity’s operations), of
• The amount of impairment losses recognised in profit or loss during the period and
the line item(s) of the statement of comprehensive income in which those impairment
losses are included; and
HKAS • The amount of impairment losses on revalued assets recognised in other
36.126 comprehensive income during the period.
When an entity reverses an impairment, HKAS 36 requires disclosure, by a class of
assets, of:
• The amount of reversals of impairment losses recognised in profit or loss during the
period and the line item(s) of the statement of comprehensive income in which those
impairment losses are reversed; and
806
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Im p a i r m ent o f Asset s
HKAS • The amount of reversals of impairment losses on revalued assets recognised in other
36.126 comprehensive income during the period.
HKAS 36 also requires a breakdown of impairment information by reportable segments,
where an entity reports segment information in accordance with HKFRS 8, including:
• The amount of impairment losses recognised in profit or loss and in other
comprehensive income during the period; and
HKAS • The amount of reversals of impairment losses recognised in profit or loss and in other
36.129 comprehensive income during the period.
HKAS In addition, the reportable segment to which an asset (or cash-generating unit) belongs
36.130 needs to be disclosed.
HKAS 36 also includes detailed requirements in relation to the circumstances giving rise to
the recognition or reversal of an impairment, including:
• The amount;
• The events and circumstances that led to the recognition or reversal of the
impairment loss;
• The nature of the asset or a description of the cash-generating unit; and
HKAS • The recoverable amount and whether the recoverable amount is its fair value less costs
36.130 of disposal or its value in use.
If the recoverable amount is the fair value less costs of disposal, the level of the fair value
hierarchy is required to be disclosed (see Chapter 5 for a discussion of HKFRS 13). In addition,
HKAS 36 requires additional disclosures if the fair value measurement is categorised as Level 2
or Level 3 of the fair value hierarchy relating to the description of the valuation technique, key
assumptions and discount rate.
HKAS If the recoverable amount is value in use, the discount rate(s) used in the current estimate
36.130 and previous estimate (if any) of value in use.
In addition, if any portion of the goodwill acquired in a business combination during the
period has not been allocated to a cash-generating unit (group of units) at the end of the
HKAS reporting period, the amount of the unallocated goodwill is required to be disclosed together
36.133 with the reasons why that amount remains unallocated.
14.7.1 Estimates Used to Measure Recoverable Amounts
of Cash-generating Units Containing Goodwill or
Intangible Assets with Indefinite Useful Lives
HKAS 36 also includes additional disclosure requirements where a cash-generating unit
includes goodwill or intangible assets with indefinite useful lives. Specifically, the following
disclosures are required if the carrying amount of goodwill or intangible assets with indefinite
useful lives allocated to that cash-generating unit (or group of cash-generating units) is
significant in comparison with the entity’s total carrying amount of goodwill or intangible assets
with indefinite useful lives:
• The carrying amount of goodwill allocated;
• The carrying amount of intangible assets with indefinite useful lives allocated; and
807
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FINANCIAL REPORTING
HKAS • The basis on which the recoverable amount has been determined, i.e. value in use or
36.130 fair value less costs of disposal.
HKAS The disclosure then depends on whether the recoverable amount is based on value in use
36.134 or fair value (Exhibit 14.18).
Value in use Fair value
• Each key assumption on which • Each key assumption on which management has
management has based its cash flow based its determination of fair value less costs of
projections for the period covered by disposal. Key assumptions are those to which the
the most recent budgets/forecasts. unit’s (group of units’) recoverable amount is most
Key assumptions are those to which sensitive.
the unit’s (group of units’) recoverable • A description of management’s approach to
amount is most sensitive. determining the value (or values) assigned to each
• A description of management’s key assumption, whether those values reflect past
approach to determining the value(s) experience or, if appropriate, are consistent with
assigned to each key assumption, external sources of information, and, if not, how and
whether those value(s) reflect past why they differ from past experience or external
experience or, if appropriate, are sources of information.
consistent with external sources of • The level of the fair value hierarchy (see Chapter 5)
information, and, if not, how and why within which the fair value measurement is
they differ from past experience or categorised in its entirety (without giving regard to
external sources of information. the observability of ‘costs of disposal’).
• The period over which management • If there has been a change in valuation technique, the
has projected cash flows based change and the reason(s) for making it. If fair value
on financial budgets and forecasts less costs of disposal is measured using discounted
approved by management and, when cash flow projections, the following information is
a period greater than five years is disclosed:
used for a cash-generating unit (group
°° The period over which management has
of units), an explanation of why that
projected cash flows;
longer period is justified.
°° The growth rate used to extrapolate cash flow
• The growth rate used to extrapolate
projections; and
cash flow projections beyond the period
covered by the most recent budgets °° The discount rate(s) applied to the cash flow
and forecasts, and the justification for projections.
using any growth rate that exceeds • If a reasonably possible change in a key assumption
the long-term average growth rate for on which management has based its determination
the products, industries, or country or of the unit’s (group of units’) recoverable amount
countries in which the entity operates, would cause the unit’s (group of units’) carrying
or for the market to which the unit amount to exceed its recoverable amount:
(group of units) is dedicated. °° The amount by which the unit’s (group of units’)
• The discount rate(s) applied to the cash recoverable amount exceeds its carrying amount;
flow projections. °° The value assigned to the key assumption; and
°° The amount by which the value assigned to the
key assumption must change, after incorporating
any consequential effects of that change on the
other variables used to measure recoverable
amount, in order for the unit’s (group of units’)
recoverable amount to be equal to its carrying
amount.
EXHIBIT 14.18 Disclosure based on value in use and fair value
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Im p a i r m ent o f Asset s
When recoverable amount is calculated, using fair value less costs of disposal, an entity is
not required to provide the disclosures required by HKFRS 13.
If some or all of the carrying amount of goodwill or intangible assets with indefinite useful
lives are allocated across multiple cash-generating units (groups of units), and the amount so
allocated to each unit (group of units) will be insignificant in comparison with the entity’s total
carrying amount of goodwill or intangible assets with indefinite useful lives. This fact is required
to be disclosed, together with the aggregate carrying amount of goodwill or intangible assets
with indefinite useful lives allocated to those units (groups of units).
In addition, disclosure is required if the recoverable amounts of any of those units (groups
of units) are based on the same key assumption(s) and the aggregate carrying amount of
goodwill or intangible assets with indefinite useful lives allocated to them is significant in
comparison with the entity’s total carrying amount of goodwill or intangible assets with
indefinite useful lives. The following disclosures are also required:
• The aggregate carrying amount of goodwill allocated to those units (groups of units);
• The aggregate carrying amount of intangible assets with indefinite useful lives allocated
to those units (groups of units);
• A description of the key assumption(s);
• A description of management’s approach to determining the value(s) assigned to the
key assumption(s), whether those value(s) reflect past experience or, if appropriate, are
consistent with external sources of information, and, if not, how and why they differ
from past experience or external sources of information; and
• If a reasonably possible change in the key assumption(s) would cause the aggregate
of the units’ (groups of units’) carrying amounts to exceed the aggregate of their
recoverable amounts:
°° The amount by which the aggregate of the units’ (groups of units’) recoverable
amounts exceeds the aggregate of their carrying amounts;
°° The value(s) assigned to the key assumption(s); and
°° The amount by which the value(s) assigned to the key assumption(s) must change
after incorporating any consequential effects of the change on the other variables
used to measure recoverable amount, for the aggregate of the units’ (groups of
HKAS units’) recoverable amounts to be equal to the aggregate of their
36.135 carrying amounts.
The most recent detailed calculation made in a preceding period of the recoverable
amount of a cash-generating unit (group of units) may, be carried forward and used in the
impairment test for that unit (group of units) in the current period provided specified criteria
are met. When this is the case, the information for that unit (group of units) that is
HKAS incorporated into the disclosures required in relation to the carried forward calculation of
36.136 recoverable amount.
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Knowledge Check Question
Question 17
Which of the following is required to be disclosed for each class of assets in relation to
impairments?
I. The amount of impairment losses recognised in profit or loss during the period
II. The amount of reversals of impairment losses recognised in profit or loss during
the period
III. The amount of impairment losses on revalued assets recognised directly in equity
during the period; and
IV. The amount of reversals of impairment losses on revalued assets recognised
directly in other comprehensive income during the period
A III and IV only
B I, II, III and IV only
C I, II and III only
D I and II only
1 4 . 8 CURRENT DEVELOPMENTS
The International Accounting Standards Board (IASB) is investigating making improvements to
HKFRS 3 (Revised) Business Combinations and to HKAS 36 following feedback received from the
Post-Implementation Review (PIR). Feedback from the PIR included:
• Investors commenting that companies provide insufficient information about goodwill
and impairment, and that impairments of goodwill are not always recognised in a
timely fashion;
• Investors commenting that existing disclosures do not provide enough information to
enable them to understand whether an acquisition was a sound investment decision
and whether the acquired business is performing as was expected at the time of the
acquisition;
• Some companies stating that the current impairment test required for goodwill under
IAS 36 Impairment of Assets is overly complex, time-consuming and expensive; and
• Separate recognition and measurement of some intangible assets is challenging.
Subsequently, the IASB published its preliminary views in a discussion paper in 2020. Those
preliminary views include that:
• It should mandate additional disclosures that would improve the information provided
to investors about acquired businesses;
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• It should simplify the accounting for goodwill and improve some aspects of the
impairment test by:
°° Improving the calculation of value in use, by removing from IAS 36 Impairment
of Assets:
–– The restriction that excludes from the calculation of value in use those
cash flows expected to result from a future restructuring or from a future
enhancement; and
–– The requirement to use pre-tax inputs in the calculation; and
°° Providing relief from the mandatory annual quantitative impairment test for
goodwill;
• It should introduce a requirement to present total equity before goodwill;
• It should continue to require identifiable intangible assets to be recognised separately
from goodwill;
°° It should not reintroduce amortisation of goodwill; and
°° It cannot make the impairment test more effective.
Any changes which may arise from this IASB project will take time to resolve, particularly
given the number of interested parties in this topic and the sensitivity over any outcomes.
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SUMMARY
Scope
• HKAS 36 does not apply to non-current assets held for sale (HKFRS 5); financial assets other
than investments in subsidiaries, associates or joint ventures (i.e. financial assets within the
scope of HKFRS 9); investment property measured at fair value (HKAS 40); or biological assets
related to agricultural activity and measured at fair value less costs to sell (HKAS 41). However,
HKAS 36 does apply to assets that are carried at revalued amount such as permitted by
HKAS 16 and HKAS 38.
Indication of impairment
• At the end of each reporting period, an entity assesses whether any indication exists of an
impairment of any assets scoped in to HKAS 36 or a reversal of an impairment of any assets
except goodwill;
• Indefinite life intangible assets, intangible assets unavailable for use and cash-generating
units, which have goodwill allocated, must also be tested for impairment annually; and
• Groups of cash-generating units with goodwill allocated to them must be tested as follows:
°° Each individual cash-generating unit must be tested for impairment if there any indications
of an impairment; and
°° An aggregated group of cash-generating units and goodwill must be tested annually
as one unit.
Recognition and measurement of impairment
• Recoverable amount is the higher of an asset’s (or cash-generating unit’s) fair value less costs
of disposal and its value in use; and
• Where an asset’s (or cash-generating unit’s) carrying amount exceeds its recoverable amount,
its carrying amount is reduced to its recoverable amount by recognising an impairment
loss. An impairment loss is recognised immediately in profit or loss except that, for an asset
measured using the revaluation model, an impairment loss is debited first against any existing
balance of revaluation surplus for that asset via other comprehensive income.
Cash-generating units, corporate assets and goodwill
• An asset’s cash-generating unit is the smallest group of assets that includes the asset and
generates cash inflows largely independent of the cash inflows from other assets or groups
of assets;
• Assets other than goodwill that contribute to the future cash flows of more than one
cash-generating unit (‘corporate assets’) are allocated to the lowest level of aggregation of
cash-generating units to which they can be allocated on a reasonable and consistent basis;
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• Goodwill acquired in a business combination is allocated to each of the acquirer’s
cash-generating units, or groups of cash-generating units, that is expected to benefit from the
synergies of the combination;
• If an entity measures non-controlling interests in a subsidiary as its proportionate interest in
the subsidiary’s net identifiable assets at the acquisition date, rather than at fair value, when
allocating goodwill to a related cash-generating unit the entity grosses up:
°° The carrying amount of goodwill allocated to the unit; and
°° Related goodwill attributable to the non-controlling interests;
• Goodwill testing may be performed at any time during an annual period, provided the test is
performed at the same time every year;
• The impairment loss for a cash-generating unit or group of cash-generating units is allocated
first to reduce the carrying amount of goodwill. Any remaining impairment is allocated to the
other assets on a pro-rata basis, provided that no asset is written down below its fair value
less costs of disposal.
Reversing an impairment loss
• If there has been a change in estimates used to determine the recoverable amount of an
asset other than goodwill previously written down for an impairment loss and the asset’s
recoverable amount exceeds its carrying amount, the asset’s carrying amount will have to be
increased to its recoverable amount. However, the asset’s carrying amount must not exceed
the carrying amount (net of depreciation/amortisation) that would have been determined if
no impairment loss had previously been recognised.
Disclosure
• In addition to various information disclosed on the impairment loss or reversal by segment,
class, cash-generating unit, or asset, there must be disclosure of the events or circumstances
that led to the recognition or reversal of the impairment loss;
• If fair value less costs of disposal is used for recoverable amount, additional information
regarding the use of the HKFRS 13 fair value hierarchy will be disclosed; and
• A range of information is required regarding the assumptions and estimates used in
measuring recoverable amounts of cash-generating units containing goodwill or intangible
assets with indefinite useful lives.
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MIND MAP
DISCLOSURE SCOPE
Disclose amounts of impairment losses Applies to all assets except non-current
recognised/reversed during the period and: assets held for sale, financial assets within
• The events or circumstances that led the scope of HKFRS 9, investment properties
to them at fair value, and biological assets at fair
• Whether recoverable amount is fair value value less costs to sell
less costs of disposal or value in use Applies to assets accounted for under
• If recoverable amount is fair value less costs either the cost model or revaluation model
of disposal, the level of the fair value in HKAS 16 or HKAS 38
hierarchy in HKFRS 13 for that fair value
measurement (and, except for Level 1 IDENTIFYING AN ASSET THAT MAY BE
measurements, the valuation techniques IMPAIRED
and key assumptions used) Assess at end of each reporting period
• if recoverable amount is value in use, the whether there is an indication of impairment
discount rate used Annually test for impairment Indefinite-life
Similar disclosures are made for intangible assets, intangible assets not yet
cash-generating units that include available for use and cash-generating units
goodwill or indefinite-life intangible to which goodwill is allocated
assets (regardless of whether impaired)
MEASURING RECOVERABLE AMOUNT
REVERSING AN IMPAIRMENT LOSS IMPAIRMENT
OF ASSETS The higher of an asset’s or cash-generating
Assess at end of each reporting period (HKAS 36) unit’s fair value less costs of disposal and
whether there is an indication of reversal its value in use
For assets other than goodwill impairment Value in use reflects how market
losses are reversed in subsequent periods participants would price the cash flows
if the recoverable amount exceeds management expects the entity to derive
(impaired) carrying amount because from the asset or cash-generating unit
of a change in estimates Fair value less costs of disposal is a
Reversal cannot exceed the current market-based value
carrying amount if the impairment loss
RECOGNISING AND MEASURING AN
was never recognised
IMPAIRMENT LOSS
CASH-GENERATING UNITS, CORPORATE Recognised when the carrying amount of
ASSETS AND GOODWILL an asset or cash-generating unit exceeds
CGU is the smallest identifiable group of its recoverable amount
assets that generates cash inflows that are Recognised immediately in profit or loss,
largely independent of the cash inflows unless the asset is measured using the
from other assets or other groups of assets revaluation model and a balance of
Corporate assets are allocated to the revaluation surplus exists for that asset
lowest level of aggregation of CGUs that is (then recognise in other comprehensive
reasonable income)
Goodwill is allocated to each of the For a cash-generating unit is allocated first
acquirer’s CGUs expected to benefit from to any goodwill and the remainder is
the synergies of the business combination allocated pro rata to the other assets,
If goodwill can only be allocated to a group but without writing an asset below fair
of CGUs, each CGU with an indication of value less costs of disposal
impairment is tested for impairment
without the goodwill and the group of CGUs
(including the goodwill) is tested annually
for impairment
Answers to Knowledge Check Questions
Question 1
Answer A is incorrect. An asset being temporarily idle during regular major maintenance
would be a planned event. All other things being equal, such an event should not affect
the asset’s previously estimated value in use. HKAS 36 identifies an asset becoming idle as
an example of an indication that the asset may be impaired: however, it is not referring to
planned major maintenance.
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Answer B is incorrect. An increase in market interest rates will only require an entity
to make a formal estimate of an asset’s recoverable amount if it materially affects the
discount rate used to estimate the asset’s value in use (i.e. the discount rate for the period
over which the asset’s future cash flows will be discounted to their present value). For
example, if an asset has a long remaining useful life and an increase in short-term market
interest rates occurs, that event will only be an indication of possible material impairment
if it is accompanied by a material increase in long-term market interest rates.
Answer C is correct. A significant decline in budgeted net cash inflows from an asset
indicates the asset’s possible impairment from internal sources of information, which
would require the entity to make a formal estimate of the asset’s recoverable amount.
Because the asset’s previously estimated recoverable amount did not significantly exceed
its carrying amount, there is not a significant buffer to incurring an impairment loss if the
asset’s economic performance is worse than previously expected.
Answer D is incorrect. A new competitor entering the market for services similar to those
rendered by an asset is a change with an adverse effect in the entity’s market environment,
which HKAS 36 identifies as an indication of possible impairment. However, the asset
in question is an intangible asset with an indefinite useful life. HKAS 36 requires the
recoverable amount of such an asset to be estimated at any time during an annual period
(but at the same time annually) regardless of whether an indication of impairment exists.
In addition, the entity would be required to estimate the recoverable amount of such an
asset between annual impairment testing if there is an indication of possible impairment
prior to the next annual test. However, because previous recoverable amount calculations
for the asset showed that its recoverable amount exceeded its carrying amount, the entry
of a new competitor to the entity would not indicate that a material impairment loss
may have occurred between annual impairment testing. Therefore, the entry of a new
competitor would not of itself require the indefinite life intangible asset’s recoverable
amount to be estimated.
Question 2
Answer A is incorrect. It is true that, when measuring an asset’s value in use in accordance
with HKAS 36, there is a rebuttable presumption that projections of cash flows based on
the most recent financial budgets and forecasts approved by management are to cover no
more than a five-year period.
Answer B is correct. It is untrue that, when measuring an asset’s value in use in accordance
with HKAS 36, assumptions on which projections of future cash flows are based must be
consistent with actual past outcomes. An entity bases cash flow projections on reasonable
and supportable assumptions that reflect management’s best estimate of the range of
economic conditions that will exist over the remaining useful life of the asset. Where future
conditions are expected to differ from those in the past, projected future cash flows should
differ from past outcomes.
Answer C is incorrect. It is true that, when measuring an asset’s value in use in accordance
with HKAS 36, there is a rebuttable presumption that, when extrapolating projections of
cash flows beyond the period covered by the most recent financial budgets and forecasts,
a steady or declining growth rate is to be used for subsequent years.
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Answer D is incorrect. It is true that, when measuring an asset’s value in use in accordance
with HKAS 36, there is a rebuttable presumption that, when extrapolating projections of
cash flows beyond the period covered by the most recent financial budgets and forecasts,
the growth rate used is not to exceed the long-term average growth rate for the products,
industries, or the country or countries in which the entity operates, or for the market in
which the asset is used.
Question 3
Nature of future Included in Included Comment
cost fair value in value in
less costs of use?
disposal?
Finance costs No No These are not direct incremental
costs of sale. Also, regarding value
in use, the time value of money
is reflected in the present value
calculation.
Company tax (arising No No Income taxes are accounted
on any profit on sale) for separately from the current
value of assets. Also, regarding
value in use, the discount rate is
determined on a pre-tax basis.
Agent’s commission Yes Yes Direct incremental cost of disposal
Advertising costs Yes Yes Direct incremental cost of disposal
Costs incurred to Yes Yes Direct incremental cost of disposal
bring the asset into
condition for sale
Cost of improving or No No Fair value less costs of disposal
enhancing the asset’s and value in use are measured
performance on the basis of the asset’s current
condition.
Stamp duty Yes Yes Direct incremental cost of disposal
Legal costs Yes Yes Direct incremental cost of disposal
Transport costs to Yes Yes Direct incremental cost of disposal
deliver the asset to
the customer
Future overheads No Yes Such costs are necessarily
that can be attributed incurred in generating cash
directly, or allocated inflows from use, but not
on a reasonable and disposal, of the asset. They are
consistent basis, to the not deducted from fair value (less
use of the asset costs of disposal) determined
using the market approach in
HKFRS 13 because the market
price incorporates assumptions
about all future cash inflows and
outflows from the use of the asset.
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An asset’s value in use includes future cash inflows and outflows from the continuing use
and ultimate disposal of the asset. Therefore, the treatment of future costs is generally
consistent between fair value less costs of disposal and value in use.
Question 4
Answer A is incorrect. HKAS 36.30(a) requires the future cash flows to include future cash
flows to be derived from the asset.
Answer B is incorrect. HKAS 36.55 requires the discount rate to reflect the current market
assessment of the time value of money.
Answer C is incorrect. HKAS 36.30(b) requires the future cash flows to reflect expectations
about possible variations in the amount or timing of those future cash flows.
Answer D is correct. Future cash inflows and outflows expected to arise from a
restructuring to which the entity is not yet committed are excluded from the calculation
of value in use because value in use is estimated for the asset in its current condition.
Once the entity becomes committed to the restructuring, it recognises a related provision
and becomes appropriate to include the enhanced cash inflows (if any) and cost savings
expected to result from the restructuring in the asset’s value in use.
Question 5
Answer A is incorrect. HKAS 36 states that a discount rate that reflects the time value of
money and the risks specific to the asset is estimated from the rate implicit in current
market transactions for similar assets or from the weighted average cost of capital of a
listed entity with a single asset (or a portfolio of assets) similar in terms of service potential
and risks to the asset under review. Therefore, it is incorrect to identify A as an untrue
statement.
Answer B is incorrect. HKAS 36 requires the discount rate used to measure an asset’s
value in use to be a pre-tax rate, consistent with the future cash flows included in value in
use being estimated on a pre-tax basis. Therefore, it is incorrect to identify B as an untrue
statement.
Answer C is correct. HKAS 36 indicates that, in the absence of better evidence of the rate
of discount to use when measuring an asset’s value in use, the entity’s weighted average
cost of capital may be taken into account. However, HKAS 36 also states that the discount
rate is independent of the entity’s capital structure and the way the entity financed the
purchase of the asset. Therefore, it is untrue to state that a discount rate reflecting the
entity’s capital structure may be used.
Answer D is incorrect. Although HKAS 36 states that an entity normally uses a single
discount rate when estimating an asset’s value in use, it also notes that an entity uses
separate discount rates for different future periods where an asset’s value in use is
sensitive to a difference in risks for different periods or to the term structure of interest
rates. Therefore, it is incorrect to identify D as an untrue statement.
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Question 6
HKAS The recoverable amount is the higher of the value in use and the fair value less costs of
36.6 disposal; therefore, the recoverable amount is the value in use amount of negative
HK$15 million (as this is greater than negative HK$22 million).
The impairment loss however is HK$11 million unless a liability is required to be
recognised by another standard (HKAS 36.62) because an asset can only be impaired to a
nil value.
Question 7
Answer A is correct. A revaluation decrement. This is the correct treatment described by
HKAS 36.60.
Answer B is incorrect. An impairment loss is a decrease (decrement) to an asset’s value not
an increase (increment).
Answer C is incorrect. When an asset is measured under the revaluation model, the
impairment loss is not adjusted (set-off) against depreciation expense.
Answer D is incorrect. When an asset is measured under the revaluation method, the
impairment loss is not adjusted (added) to the depreciation expense.
Question 8
An impairment will arise immediately upon an asset being revalued to the fair value under
the revaluation model if:
• An impairment review is required;
• The asset’s fair value less costs of disposal includes significant disposal costs; and
• The asset’s value in use is less than its fair value less costs of disposal (i.e.
recoverable amount is fair value less costs of disposal) or exceeds that amount by
less than the amount of the entity’s costs of disposal.
Question 9
Answer A is incorrect. Although you have calculated the correct carrying amount of
HK$412.5 million following the recognition of the impairment loss, the impairment loss
will be applied initially to the balance of revaluation surplus existing with respect to the
crane (HK$250 million) by recognising that reduction in revaluation surplus in other
comprehensive income. The remainder of the impairment loss (HK$50 million) is then
recognised as a loss in profit or loss. Therefore, recognising the entire impairment loss of
HK$300 million in profit or loss is incorrect (as in your selected answer).
Answer B is incorrect. You have not taken the accumulated depreciation of HK$37.5 million
because the crane was revalued into account when calculating the carrying amount prior
to its reduction by the impairment loss of HK$300 million. However, you allocated correctly
the portions of the impairment loss recognised, respectively, in other comprehensive
income and profit or loss.
Answer C is correct. The revised carrying amount of the high performance crane is
HK$412.5 million, with HK$250 million recognised in other comprehensive income and
HK$50 million recognised in profit and loss. The carrying value of the high performance
crane immediately before recognition of the impairment loss is HK$712.5 million
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(HK$750 million less HK$37.5 million). Because the impairment loss recognised
is HK$300 million, this indicates the recoverable amount of the impaired crane is
HK$412.5 million. The balance of the revaluation surplus for the crane is HK$250 million
(calculated as HK$750 million less HK$500 million) and this is the amount by which
the impairment loss is debited to other comprehensive income. The remainder of the
impairment loss (HK$50 million) must be recognised in profit or loss.
Answer D is incorrect. Although you have calculated the correct carrying amount of
HK$412.5 million following the recognition of the impairment loss, the impairment
loss is recognised in other comprehensive income only to the extent of the balance of
revaluation surplus existing in respect of the crane (HK$250 million). The remainder of
the impairment loss (HK$50 million) is then required to be recognised as an expense in
profit or loss. Therefore, recognising the entire impairment loss of HK$300 million in other
comprehensive income is incorrect (as in your selected answer).
Question 10
The recoverable amount of the supertanker is the higher of value in use and fair value
less costs of disposal. To determine the correct value in use amount, the requirements
of HKAS 36.30 to HKAS 36.57 must be complied with. HKAS 36.44 requires the future
cash flows used in the value in use calculation to be estimated for the asset in its current
condition, and HKAS 36.50 requires those estimates to exclude income tax receipts or
payments. Therefore, the net present value of HK$580 million using the future cash flows
included in ABC Limited’s (ABC) management budget and forecast without adjustment is
not suitable.
The net present value calculation of HK$400 million provided to the bank has been
prepared in accordance with the value in use requirements of HKAS 36 and, although not
the usual basis of future cash flows (budgets and forecast are usually used), is to be used
as the value in use estimate.
For the fair value less costs of disposal, the management of ABC considers using the
offer received from DEF Limited (DEF) or the publicly available information on the sale of
smaller supertanker.
The offer from DEF of HK$500 million less costs of disposal identified in HKAS 36.28
of stamp duty (HK$50 million) and agent’s fees (HK$20 million) results in an estimate
of fair value less costs of disposal value of HK$430 million. HKAS 36.28 does not permit
redundancy costs to be treated as a cost of disposal.
The publicly available information about the net selling price of a smaller supertanker
is highly credible because it is a publicly reported sale of a similar vessel. However, it is not
considered to be a suitable basis for measuring the fair value less costs of disposal of ABC’s
supertanker because:
• The transaction is two years old and the data are, therefore, becoming stale; and
• The transaction is for a much smaller vessel and is, therefore, not a suitable proxy
for ABC’s supertanker. In addition, insufficient market data exist for adjusting for the
difference between the capacities of the two supertankers because the fair value of
supertankers does not increase linearly with capacity.
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Therefore, the most appropriate estimate of the supertanker’s fair value less costs of
disposal is HK$430 million.
The supertanker’s recoverable amount is the greater of its fair value less costs of
disposal (HK$430 million) and its value in use (HK$400 million) and, therefore, is calculated
as HK$430 million.
The supertanker has a carrying amount of HK$495 million and, therefore, an
impairment loss of HK$65 million is required to be recognised.
Because the supertanker is measured using the cost model, the journal entry to
recognise the impairment loss is:
Debit Credit
HK$m HK$m
Impairment loss (profit or loss) 65
Accumulated depreciation and impairment losses 65
Question 11
Pleats Limited (Pleats) has two cash-generating units in relation to its cotton production
and processing operations:
1. The cotton farm (to the point of picked and baled cotton) is one cash-generating
unit. Although all of the grown cotton is used internally as an input to the
manufacture of cotton fabric, the fact that cotton is global commodity for which
an active market exists means that HKAS 36 requires the group of assets used to
produce the cotton to be identified as a separate cash-generating unit.
2. The cotton processing factory is the other cash-generating unit. It generates cash
inflows independently of the cash inflows from other assets or groups of assets.
Question 12
Answer A is incorrect. You have not allocated to cash-generating unit A its share of the
carrying amount of the head office assets. Consequently, you have compared a carrying
amount of HK$700 million with a recoverable amount of HK$750 million, thus, not
identifying an impairment loss.
Answer B is incorrect. You have incorrectly allocated 25% of the cost of the head office
assets (not 50% as per the actual usage) to cash-generating unit A. Therefore, you
have compared a carrying amount of HK$800 million for cash-generating unit A with a
recoverable amount of HK$750 million, and identified an impairment loss of HK$50 million.
Answer C is correct. HK$150 million. Because the head office assets are used equally by
cash-generating units A and B, the carrying amount of those assets is allocated equally
to both cash-generating units. Therefore, the assets of cash-generating unit A have a
carrying amount of HK$900 million (HK$700 million plus HK$200 million), which exceeds
the recoverable amount for cash-generating unit A of HK$750 million. Consequently,
cash-generating unit A has suffered an impairment loss of HK$150 million.
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Answer D is incorrect. You have either:
• Allocated the head office assets on an equal basis but incorrectly included the
carrying amount of cash-generating unit B (not cash-generating unit A), resulting
in the comparison of a carrying amount of HK$1,100 million (i.e. HK$900 million +
HK$200 million) with the recoverable amount of HK$750 million, thus identifying an
impairment loss of HK$350 million; or
• Allocated 100% of the carrying amount of the head office assets to cash-generating
unit A (HK$400 million), thus comparing a carrying amount of HK$1,100 million
(i.e. HK$700 million + HK$400 million) with a recoverable amount of HK$750 million
and therefore identifying an impairment loss of HK$350 million.
Question 13
Answer A is incorrect. You have incorrectly calculated the impaired carrying amount of
plant and equipment as its fair value less costs of disposal (HK$310 million) even though
that amount is less than the share of the cash-generating unit’s value in use attributable to
plant and equipment (HK$352 million).
Answer B is incorrect. You omitted to allocate the impairment loss for the cash-generating
unit to reduce the balance of goodwill first. Instead, you applied the entire impairment
loss for the cash-generating unit pro rata to all assets on the basis of their relative
pre-impairment carrying amounts (i.e. calculated the impaired carrying amount of plant
and equipment as (HK$630 million ÷ HK$750 million) × HK$400 million, resulting in a
carrying amount of plant and equipment of HK$336 million).
Answer C is correct. HK$352 million. The cash-generating unit’s recoverable amount is
calculated as HK$630 million and its impairment loss is calculated as HK$120 million. The
impairment loss of HK$120 million is applied to goodwill first. Any remaining impairment is
allocated to other assets of the cash-generating unit pro rata on the basis of their relative
carrying amounts, subject to the requirement not to write down any asset below its fair
value less costs of disposal. Because the impairment loss for the cash-generating unit
(HK$120 million) exceeds the carrying amount of goodwill (HK$50 million), the goodwill
is fully impaired, leaving a further HK$70 million impairment loss to be allocated to the
other assets. The aggregate carrying amount of the other assets is HK$700 million and
the remaining impairment loss to allocate is HK$70 million; therefore, the prima facie
impairment percentage for each class of assets (expressed as a percentage of carrying
amount) is 10%. The table below sets out the method of calculating the allocation of
the impairment loss (after goodwill is fully impaired) to each asset. Based on these
calculations, the carrying amount of plant and equipment after fully allocating the
HK$120 million impairment loss for the cash-generating unit is HK$352 million (calculated
as the pre-impairment carrying amount of HK$400 million minus an impairment loss of
HK$48 million).
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Steps in pro rata allocation Buildings Plant and Licence Total
of remaining impairment loss equipment
HK$m HK$m HK$m HK$m
Carrying amount of remaining assets 200 400 100 700
Tentative allocation of impairment (20) (40) (10) (70)
loss (first round)
Resulting tentatively revised carrying 180 360 90 630
amount
Fair value less costs of disposal 190 310 75 575
Impairment loss unable to be fully 10 – – 10
allocated
Reallocation of impairment loss – (8.0) (2.0) (10.0)
(second round)
Calculation – (360 ÷ 450) × (90 ÷ 450) × –
10.0 10.0
Resulting revised carrying amount 190 352 88 630
Total allocation of impairment loss (10) (48) (12) (70)
Answer D is incorrect. You overlooked the requirement that, when allocating an
impairment loss for a cash-generating unit, an entity shall not reduce the carrying amount
of an asset below its fair value less costs of disposal. Consequently, after reducing the
carrying amount of goodwill to zero, you have allocated the remainder of the impairment
loss (HK$70 million) pro rata to the other assets despite consequently causing the buildings
to be written down to HK$180 million, which is HK$10 million less than their fair value less
costs of disposal. As a result, you miscalculated the impaired carrying amount of plant and
equipment as HK$360 million.
Question 14
The carrying amount of the cash-generating unit after recognising the impairment loss
would be HK$640 million. If HK$10 million of the impairment loss based on value in
use were unallocable, this would indicate that the sum of the ‘fair value less costs of
disposal’ measurements for the classes of assets composing the cash-generating unit is
HK$640 million, which exceeds the value in use of HK$630 million. Consequently, being
the higher amount, the fair value less costs of disposal of each class of assets in the
cash-generating unit (HK$640 million) should be used to measure the cash-generating
unit’s recoverable amount, and therefore, the carrying amount of the cash-generating unit
after recognising the impairment loss would be HK$640 million.
Question 15
Each of Alpha Centauri’s cash-generating units to which the goodwill acquired in the
business combination has been allocated (units A, C and E) is required to be tested for
impairment annually and whenever there is an indication that the unit may be impaired.
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The annual impairment test for cash-generating units A, C and E may be performed at
any time during an annual period provided the test is performed at the same time every
year. However, this general principle is overridden by the one-off requirement in HKAS 36
for those cash-generating units to be tested for impairment on 31 December 20X8 even
though that reporting date precedes the end of the annual period that began when
the goodwill was acquired. HKAS 36 states that, if some or all of the goodwill allocated
to a cash-generating unit is acquired in a business combination during the current
annual period, that unit will have to be tested for impairment before the end of that
annual period.
HKAS 36 provides practical relief that, if the initial allocation of goodwill cannot be
completed before the end of the annual period in which the business combination is
effected, the initial allocation must be completed before the end of the first annual period
beginning after the acquisition date. In the case of Alpha Centauri, that would mean that
if the initial allocation of goodwill cannot be completed before 31 December 20X8, it must
be completed by 31 May 20X9. In such circumstances, cash-generating units A, C and E
would not be required to be tested for impairment on 31 December 20X8 as a result of the
acquisition of the goodwill because Alpha Centauri would not have identified the affected
cash-generating units.
Cash-generating unit B includes an intangible asset with an indefinite useful life, and
Cash-generating unit D includes an intangible asset that is unavailable for use. HKAS 36
requires each of those assets to be tested for impairment annually and whenever there is
an indication that it may be impaired. The annual impairment test for those assets may be
performed at any time during an annual period provided the test is performed at the same
time every year. However, as with the goodwill allocated to cash-generating units during
the year ended 31 December 20X8, HKAS 36 requires both of those identifiable intangible
assets to be tested for impairment on 31 December 20X8 even though that reporting
date precedes the end of the annual period that began when the asset was initially
recognised. HKAS 36 states that, if such an intangible asset was initially recognised during
the current annual period, the asset is to be tested for impairment before the end of that
annual period.
In addition, if there is any indication an asset of Alpha Centauri may be impaired on
31 December 20X8, Alpha Centauri must estimate the recoverable amount of the asset.
Therefore, the cash-generating units of Alpha Centauri to which acquired goodwill was not
allocated on 31 December 20X8 (cash-generating units B, D, F, G and H) are only required
to be tested for impairment on 31 December 20X8 if:
• The intangible asset with an indefinite useful life (cash-generating unit B) or the
intangible asset not yet available for use (cash-generating unit D) cannot be tested
for impairment separately from the cash-generating unit to which it belongs; or
• There is an indication that an asset of Alpha Centauri may be impaired on
31 December 20X8 and it cannot be tested for impairment separately from the
cash-generating unit to which it belongs.
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FINANCIAL REPORTING
Question 16
Answer A is incorrect. In reversing the previous (31 December 20X2) impairment loss, you
have reinstated the carrying amount that existed immediately prior to the impairment loss
recognised on that date (HK$14.0 million). However, the recoverable amount of the item of
equipment has not risen to that pre-impairment carrying amount, nor have you taken into
account that depreciation for two years should be recognised.
Answer B is incorrect. You have increased the carrying amount of the item of equipment
to its recoverable amount on 31 December 20X4 (HK$11.0 million) without considering
the constraint that the carrying amount of that item must not exceed the amount that
would have been recognised on that date had the impairment loss not been recognised on
31 December 20X2 (HK$10.0).
Answer C is incorrect. In reversing the previous (31 December 20X2) impairment loss, you
have reinstated the carrying amount that existed immediately after that impairment loss
was recognised (HK$10.5 million). However, the previous recoverable amount is different
in principle from the carrying amount of the item of equipment that would have been
recognised on the current reporting date (i.e. 31 December 2014) had the impairment loss
not been recognised on 31 December 20X2. For example, you have not taken into account
that depreciation for two years should be recognised.
Answer D is correct. HK$10.0 million. This is calculated as the lower of the item of
equipment’s recoverable amount on 31 December 20X4 (HK$11.0 million) and the carrying
amount of that item that would have been recognised on that date had the impairment
loss not been recognised on 31 December 20X2 (HK$10.0 million). The latter amount is
calculated as the pre-impairment carrying amount on 31 December 20X2 (HK$14.0 million)
minus two years of depreciation charges based on that pre-impairment carrying amount
(i.e. HK$20 million ÷ 10 years total useful life × 2 years = HK$4.0 million).
Question 17
Answers A, C and D are incorrect. These statements do not include the complete
requirements.
Answer B is correct. I, II, III and IV as all of the following disclosures are required by
HKAS 36 for impairments of each class of assets:
I. The amount of impairment losses recognised in profit or loss during the period;
II. The amount of reversals of impairment losses recognised in profit or loss during
the period;
III. The amount of impairment losses on revalued assets recognised directly in equity
during the period; and
IV. The amount of reversals of impairment losses on revalued assets recognised
directly in other comprehensive income during the period.
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EXAM PRACTICE
QUESTION 1
(Adapted from Module A December 2016 exam)
Pacific Holdings Limited (PHL) is a company listed on the Stock Exchange of Hong Kong and
is principally engaged in the real estate industry in mainland China. PHL has grown over the
past few years through the acquisition of companies in mainland China. However, business
was tough in the year of 2015.
Semantic Property Limited
On 1 January 2012, PHL acquired an 80% interest in Semantic Property Limited (SPL) for RMB
480 million when the equity of SPL was:
RMB’000
Share capital 100,000
Retained earnings 240,000
Other reserves 160,000
500,000
The carrying amounts of assets and liabilities of SPL were the same as their fair values
except for non-current assets for which the fair value was RMB 40 million greater than the
carrying amount. The non-current assets had a remaining economic life (same as useful life)
of 10 years. The control premium for the controlling interest was considered to be minimal
and thus ignored.
It is the Group’s policy to measure the non-controlling interests as the proportionate
share of the fair value of the identifiable net assets of the subsidiary at the acquisition-date.
Impairment review of SPL
An impairment review has been performed on SPL at 31 December 2015. The recoverable
amounts of SPL as a cash-generating unit on 31 December 2015 was RMB 628 million
though the book value of the relevant assets for impairment review (excluding goodwill) was
RMB 658 million after adjusting for the effects of unrealised profits and fair value adjustment
on consolidation. The directors of PHL believed that any impairment of assets was not due
to the current assets. No adjustments have been made in the financial statements in relation
to this impairment review.
Required:
Advise as to the appropriate accounting treatment for the impairment review of SPL.
Calculations and journal entry(ies) are required.
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FINANCIAL REPORTING
QUESTION 2
(Adapted from Module A December 2017 Exam)
Nice Homes Limited (NHL) runs four stores selling antique furniture and home accessories
in various cities in mainland China. Each store makes all its retail purchases through NHL’s
purchasing centre, and all stores are managed in the same way. Marketing, advertising
and human resources functions are conducted and centralised in NHL’s headquarters.
Each store has its own customer base and generates daily sales information and monthly
statements of profit or loss for management to make decisions about continuing to operate
individual stores. NHL has a small research centre to analyse the purchasing behaviour of
the customers for all stores.
At its recent management meeting, the Sales Director has expressed his concern about
the decrease in sales performance of stores in some cities due to keen competition in that
region and a change in the desire of customers for stylish modern furniture. The Sales
Director is considering to re-allocate resources to enhance the profitability of the company
and has asked the Finance Director whether impairment assessment should be performed
at entity level for NHL as a whole or at store level.
According to management’s decision, the carrying amount of the headquarters’ building
can be allocated to the cash-generating units under review, but the carrying amount of the
research centre cannot be allocated. The allocation basis of the headquarters’ building is
based on the carrying amount of the stores weighted by the estimated remaining useful life
of their assets.
On 31 December 2016, the following financial data were obtained:
Carrying amount Estimated remaining Recoverable
of relevant assets useful life of the amount
assets (years)
HK$’000 HK$’000
Store A 4,300 6 3,100
Store B 5,400 9 6,200
Store C 6,000 10 7,000
Store D 3,800 5 3,500
Total 19,500 19,800
Recoverable amount of NHL as a whole: 21,000
Carrying amount of headquarters’ building: 1,800
Carrying amount of research centre: 1,000
Required:
(a) Assume you are the Finance Director of NHL, based on the background information,
advise the Sales Director at what level should NHL conduct its impairment assessment
for the year ended 31 December 2016.
(b) Determine the impairment of assets, with detailed calculation, if any, to be recognised
by NHL on 31 December 2016.
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QUESTION 3
(Adapted from Module A December 2018 Exam)
Kowloon Group Holding Limited (KGH) is an e-commerce and technology conglomerate that
provides consumer-to-consumer, business-to-consumer and business-to-business sales
services via web portals. It is listed on the Main Board of the Hong Kong Stock Exchange
(HKex). KGH has grown over the past few years through the acquisition of companies,
including BGM Limited (BGM).
Impairment of goodwill of BGM
In a meeting of the board of directors, Jody Wong, one of the directors, raised the
following concern:
‘I know that we have to pay HK$22,400 million for such an acquisition though the financial
statements of BGM show only a book value of net assets of HK$15,000 million. In fact, BGM is a
loss-making company. As the goodwill pertains to BGM, there will be an impairment of goodwill
immediately after acquisition amounting to HK$7,400 million which will greatly affect our
profitability.’
However, the Chief Financial Officer replied as follows:
‘KGH is positioning itself well in the Chinese market. The company dominates the e-commerce space
in China and will now operate the leading supermarket chain. KGH can effectively gain expertise
in bricks and mortar retail and use its data-driven approach to integrate the online and offline
shopping experience for customers. The purchase of BGM will benefit KGH as a whole and achieve
a synergy between our online and offline businesses. Online and offline businesses are expeted
to benefit from the synergies of the combination, and thus, goodwill impairment will never be
calculated for BGM alone’.
Required:
Assume that you are Philip Chan, the accounting manager for BGM.
Draft a memorandum explaining the accounting principles in relation to the goodwill
allocation and impairment of goodwill of BGM.
ANS W ERS TO E X AM PRA C T I C E
QUESTION 1
Impairment review of Semantic Property Limited (SPL)
Goodwill on the acquisition of SPL
RMB’000 RMB’000
Book value of identifiable net assets acquired 500,000
Fair value adjustment of non-current assets 40,000
Fair value of identifiable net assets acquired 540,000
Consideration transferred 480,000
Non-controlling interest (540 × 20%) 108,000
Thus, total cost of acquisition 588,000
Goodwill 48,000
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FINANCIAL REPORTING
Because Pacific Holdings Limited (PHL) measures non-controlling interests as its
proportionate interest in the net identifiable assets of a subsidiary at the acquisition date
rather than at fair value, goodwill attributable to non-controlling interests is included in the
recoverable amount of the related cash-generating unit, i.e. Semantic Property Limited’s
C4 of
App. C of (SPL) recoverable amount, but is not recognised in the parent’s consolidated financial
HKAS 36 statements.
Therefore, PHL should gross up the carrying amount of goodwill allocated to SPL to
include the goodwill attributable to the non-controlling interests. This adjusted carrying
amount is then compared with the recoverable amount of the unit to determine whether the
cash-generating unit is impaired.
Impairment review of SPL
RMB’000
Goodwill recognised 48,000
Relevant assets at 31 Dec 2015 658,000
Carrying amount at 31 Dec 2015 706,000
Goodwill for NCI (48 × 20/80) 12,000
Adjusted carrying amount at 31 Dec 2015 718,000
Recoverable amount (628,000)
Impairment loss 90,000
Because the directors of PHL believe that any impairment of assets is not due to the
current assets, the impairment loss will not be allocated to the current assets.
Thus, for the impairment of SPL, goodwill of RMB 60 million should be written off first;
then, the balance RMB 30 million (i.e. RMB (90 – 60) million) should be allocated to the
non-current assets.
Because PHL recognised the goodwill only up to 80% ownership interest in SPL, PHL
should only recognise RMB 48 million goodwill impairment loss and RMB 30 million
impairment loss on non-current assets.
A3 Recognise impairment of SPL
Debit Credit
RMB million RMB million
Impairment loss (I/S) 78
Goodwill 48
Non-current assets 30
QUESTION 2
(a) The objective of HKAS 36 Impairment of Assets is to ensure an entity’s assets are carried
at no more than their recoverable amount.
The recoverable amount is determined for an individual asset unless the asset
does not generate cash inflows that are largely independent of those from other
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Im p a i r m ent o f Asset s
assets or groups of assets. If this is the case, recoverable amount is determined for the
cash-generating unit (CGU) to which the asset belongs unless:
• The asset’s fair value less costs of disposal is higher than its carrying amount; or
• The asset’s value in use can be estimated to be close to its fair value less costs of
disposal and fair value less costs of disposal can be measured.
A CGU is the smallest group of assets that includes the asset and generates largely
independent cash inflows.
Based on the information provided, each store generates its own cash flows that
are largely independent of other stores by having a different customer base. Each
individual store also produced daily sales information and monthly statements of profit
or loss. Therefore, although managed at the central level, individual stores generate
largely independent cash inflows of other stores. Thus, it is likely that each store
represents a CGU.
Corporate assets are assets other than goodwill that contribute to the future cash
flows of the cash-generating unit under review and the other CGUs. Corporate assets
do not generate cash inflows independently of other assets or groups of assets, and
their carrying amount cannot be fully attributed to the CGU under review.
The corporate asset should be tested as part of a CGU because it does not generate
independent cash flows, and so its stand-alone value in use cannot be estimated.
A fair value might be established for corporate assets, such as a brand or corporate
headquarters. If the fair value less costs of disposal is higher than the carrying amount,
the corporate asset is not impaired and a test at the CGU level will not be necessary.
NHL should perform assessment at the lowest level of its CGU, i.e. the store level.
(b) Though the recoverable amount of Nice Homes Limited (NHL) is higher than the
carrying value of the NHL as a whole, NHL has to assess impairment at the lowest level
CGU, i.e. the store level. The headquarters’ building should be allocated to the stores.
Calculation of a weighted allocation of the carrying amount of the headquarters’ building
Carrying Estimated Carrying Allocation of
amount of remaining amount after carrying value of
relevant useful life of weighting headquarters’
assets the assets building
(years)
HK$’000 HK$’000 HK$’000
Store A 4,300 6 25,800 303
Store B 5,400 9 48,600 570
Store C 6,000 10 60,000 704
Store D 3,800 5 19,000 223
Total 19,500 30 153,400 1,800
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FINANCIAL REPORTING
Impairment testing of the CGU
Carrying Carrying Carrying Recoverable Impairment
amount of amount of amount amount loss
relevant allocated after
assets headquarters’ allocation
building
HK$’000 HK$’000 HK$’000 HK$’000 HK$’000
Store A 4,300 303 4,603 3,100 1,503
Store B 5,400 570 5,970 6,200 0
Store C 6,000 704 6,704 7,000 0
Store D 3,800 223 4,023 3,500 523
Total 19,500 1,800 21,300 2,026
Allocation of impairment losses to the headquarters’ building and to CGU
Impairment loss To headquarters’ To assets in CGU
building
HK$’000 HK$’000 HK$’000
Store A 1,503 99 1,404
Store D 523 29 494
Total 2,026 128 1,898
Impairment testing the smallest group of CGU to which the carrying amount of the research
centre can be allocated (i.e. NHL as a whole)
Carrying Impairment Carrying Recoverable
Amount loss at NHL amount after amount
as a whole impairment
HK$’000 HK$’000 HK$’000 HK$’000
Store A 4,300 1,404 2,896
Store B 5,400 – 5,400
Store C 6,000 – 6,000
Store D 3,800 494 3,306
Headquarters 1,800 128 1,672
Research centre 1,000 – 1,000
Total 22,300 2,026 20,274 21,000
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Im p a i r m ent o f Asset s
Impairment loss to be recognised by NHL for the year ended 31 December 2016:
Debit Credit
HK$ HK$
Impairment loss (Profit & Loss) 2,026,000
Assets in the store A 1,404,000
Assets in the store D 494,000
Headquarters’ building 128,000
Because the recoverable amount of NHL as a whole is higher than its carrying value after
impairment, no further impairment loss is required.
QUESTION 3
To : Mr Jody Wong, Director
From : Philip Chan, Accounting
Manager Date : dd/mm/yyyy
Subject : Goodwill allocation and impairment of goodwill
I refer to your query regarding goodwill allocation and impairment of goodwill of BGM
Limited (BGM).
Goodwill allocation and impairment
Because goodwill cannot generate cash independently, it must be allocated to the smallest
identifiable group of assets that generates cash inflows largely independent of the cash
inflows from other assets or groups of assets, i.e. cash-generating units (‘CGUs’).
HKAS 36 specifies that:
(a) The goodwill should, from the acquisition date, be allocated to each of the
acquirer’s cash-generating units, or groups of cash-generating units, that are
expected to benefit from the synergies of the business combination, irrespective of
HKAS whether other assets or liabilities of the acquiree are assigned to those units or
36.80 groups of units; and
(b) Each unit or group of units to which the goodwill is allocated should:
°° Represent the lowest level within the entity at which the goodwill is monitored
for internal management purposes; and
°° Not be larger than an operating segment determined in accordance with
HKFRS 8 Operating Segments.
HKAS 36.BC139 also mentions that because ‘the board was concerned that in the
absence of any guidance on the precise meaning of ‘allocated on a reasonable and
consistent basis’, some might conclude that when a business combination enhances the
value of all of the acquirer’s pre-existing cash-generating units, any goodwill acquired in that
business combination should be tested for impairment only at the level of the entity itself.
The board concluded that this should not be the case.’
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FINANCIAL REPORTING
Thus, all goodwill arising in a business combination must be allocated to CGUs or CGU
groups that benefit from synergies; none may be allocated to CGUs or CGU groups that do
not benefit, and entities are not permitted to test for impairment at the level of the entity
as a whole.
Though BGM operates an offline business only because the KGH’s existing online
business and the BGM’s offline business to be acquired are expected to benefit from the
synergies of the business combination, goodwill should be allocated to those CGUs and CGU
groups of online and offline businesses.
Because goodwill should be allocated to those CGUs and CGU groups expected to
benefit from the synergies, impairment test should not be performed for BGM as an entity
as a whole because BGM has CGUs lower than the entity as a whole.
Besides, the synergy of the combination (e.g. improve margin through cost savings and
economies of scale and opportunity for future growth through the benefit of combined
talent and technology) would mean that the recoverable amount of CGUs may well be above
the book value of net assets.
An asset is impaired when its carrying amount exceeds its recoverable amount. Because
the impairment review is not only performed on BGM at the entity level and because of
the synergy effect, the recoverable amount of the CGUs may be higher than the carrying
amount of the CGUs to which goodwill has been allocated and therefore there may be no
impairment.
I hope the above explanation has answered your question. Please feel free to contact me
if you have further queries.
Best Regards,
Philip Chan
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15
Non-current Assets Held
for Sale and Discontinued
Operations
CHAPTER TOPIC LIST
15.1 Overview 15.2.2 R ecognition of Impairment
15.1.1 Scope Losses and Reversals
15.1.2 Terminology 15.2.3 Changes to a Plan
15.1.3 Classification of Non-current of Sale or to a Plan
Assets (or Disposal Groups) of Distribution to Owners
as Held for Sale or as Held 15.3 Presentation and Disclosure
for Distribution to Owners 15.3.1 P resenting Discontinued
15.2 Measurement of Non-current Operations
Assets (or Disposal Groups) 15.3.2 Gains or Losses Relating
Classified as Held for Sale to Continuing Operations
15.2.1 M
easurement of a 15.3.3 Presentation of a Non-
Non-current Asset current Asset or Disposal
(or Disposal Group) Group Classified as Held
for Sale or Distribution
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FINANCIAL REPORTING
LEARNING OUTCOMES
PRINCIPAL LO3: EVALUATE AND ADVISE ON APPROPRIATE ACCOUNTING PRINCIPLES TO ACCOUNT
FOR COMPLEX BUSINESS TRANSACTIONS
LO3.11: A
ccount for, evaluate and advise on business transactions in accordance with Hong Kong
Financial Reporting Standards as they relate to: non-current Assets held for Sale and
Discontinued Operations
3.11.01 C
lassify non-current assets (or disposal groups) as held for sale or as held for distribution to
owners and discontinued operations
3.11.02 E
valuate and consider when a sale is highly probable
3.11.03 E
xplain what assets are within the measurement provision of non-current assets held for
sale and discontinued operations
3.11.04 A
pply the principles of measurement to non-current assets (or disposal groups) held for
sale or distribution to owners and discontinued operations, including initial measurement,
subsequent measurement and change of plan of sale
3.11.05 A
ccount for impairment loss and subsequent reversal
3.11.06 A
ccount for assets ceased to be classified as held for sale
3.11.07 P
repare disclosure in respect of non-current assets held for sale or distribution to owners
and discontinued operations, including the prior year restatement
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N on- current A ssets H eld for Sale and D iscontinued O perations
OPENING CASE
STAR PROVIDER
S tar Provider Limited (Star Provider) has been a retailer of various services, operating
throughout China, South Korea and Japan. Star Provider’s purpose has been to be a ‘one
stop shop’ for customers’ retail utility needs, including telecommunication, electricity, gas and
broadband internet.
The company has been going through a period of significant change and purchased a
supermarket chain in 20X4. Star Provider offers additional discounts on supermarket products
to customers that also purchase the company’s other services. The supermarket retail industry
has proved challenging due to strong competition from specialty grocers throughout the region
and increases in wholesale and distribution costs. During March 20X8, Star Provider began
planning for the sale of its supermarket chain.
Star Provider recently relocated its head office from Hong Kong to Shenzhen. During May
20X8, Star Provider decided to sell the Hong Kong office building and land, and began looking
for a potential buyer.
In June 20X5, Star Provider embarked on a vertical integration strategy whereby it began
purchasing telecommunication towers to help meet its retailing needs. With improvements
in technology, Star Provider now requires fewer telecommunications towers. During the year
20X7, Star Provider decided to sell a telecommunications tower located in the outskirts of
Busan, South Korea. As of 31 December 20X8, the company has yet to find a buyer for the
telecommunications tower.
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FINANCIAL REPORTING
OVERVIEW
Entities routinely decide to sell major assets or discontinue business operations. Such decisions
can have a significant impact on an entity’s statement of financial position and future cash flows,
and therefore, adequate disclosure of relevant information is important to users of financial
statements. Significant judgement is often required when applying HKFRS 5 Non-current Assets
Held for Sale and Discontinued Operations, particularly in determining whether to classify a
non-current asset (or disposal group) as held for sale or distribution. That classification, as will
be explained, can have material effects on the financial statements of the entity.
This chapter considers the classification, measurement and disclosure requirements
for non-current assets (and disposal groups) classified as held for sale or distribution and
considers the presentation and disclosure requirements for discontinued operations. Further
details related to Star Provider’s operations are used to illustrate the application of HKFRS 5.
1 5 . 1 OVERVIEW
The accounting for non-current assets held for sale and discontinued operations is set out in
HKFRS 5 Non-current Assets Held for Sale and Discontinued Operations.
The objective of HKFRS 5 is to specify the classification, measurement and disclosure
requirements for non-current assets (and disposal groups) classified as held for sale or
distribution.
In this section, you will develop an understanding of the terminology relevant to the
application of the standard and the items to which the classification, presentation and
measurement of HKFRS 5 applies.
15.1.1 Scope
HKFRS 5 requires that a non-current asset (or disposal group) be classified as held for sale if its
carrying amount will be recovered principally through a sale transaction rather than through
HKFRS continuing use. The inclusion of disposal groups is to cover the possibility that a group of
5.4 assets, with some associated liabilities, will be sold in a single transaction.
HKFRS The classification and presentation requirements of HKFRS 5 apply to all recognised
5.2 non-current assets and disposal groups classified as held for sale.
HKFRS In general, under HKFRS 5, a non-current asset (or disposal group) is measured at the lower
5.15 of carrying amount and fair value less costs to sell. However, the measurement requirements
of HKFRS 5 do not apply to all recognised non-current assets. The exceptions are:
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N on- current A ssets H eld for Sale and D iscontinued O perations
• Deferred tax assets (see Chapter 19);
• Assets arising from employee benefits (see Chapter 23);
• Financial assets within the scope of HKFRS 9 Financial Instruments (see Chapter 12);
• Non-current assets accounted for in accordance with the fair value model in HKAS 40
Investment Property (see Chapter 8);
• Non-current assets measured at fair value less costs to sell in accordance with HKAS 41
Agriculture (see Chapter 26); and
HKFRS
5.5 • Groups of contracts within the scope of HKFRS 17 Insurance Contracts (see Chapter 26).
These non-current assets are excluded from the measurement scope of HKFRS 5 as they
HKFRS are either already carried at fair value with changes in fair value recognised in profit or loss or
5.BC13 there may be difficulties in determining their fair value.
The classification, presentation and measurement requirements in HKFRS 5 applicable to
a non-current asset (or disposal group) classified as held for sale apply to a non-current asset
HKFRS (or disposal group) classified as held for distribution to owners acting in their capacity as
5.5A owners (held for distribution to owners).
In addition, HKFRS 5 sets down presentation and disclosure requirements for discontinued
operations. Those operations are a component of an entity that can be clearly distinguished,
operationally and for financial reporting purposes, from the rest of the entity. These are
discussed in Section 15.3.
15.1.2 Terminology
Exhibit 15.1 introduces some of the language and meanings, and it highlights some of the
interrelationships among that language used in HKFRS 5 and in this chapter. The elements of
Exhibit 15.1 will be returned to during the chapter.
Item Classification Measurement Disclosure
Lower of carrying
Discontinued
Non-current asset Held for sale amount and fair value
operations
less costs to sell
Lower of carrying
Component of an entity disposed
Disposal group Held for distribution amount and fair value
of or classified as held for sale and:
less costs to distribute
• Represents a separate major line
of business or geographical area
An asset that does not of operations;
meet the definition of Non-current asset or disposal
group with a carrying amount • Is part of a plan to dispose of a
a current asset Costs to distribute include separate major line of business
that will be recovered principally
incremental costs directly or geographical area of
through a sale transaction rather
attributable to distribution, operations; or
than continuing use
excluding finance costs and • Is a subsidiary acquired
A group of assets to be disposed income tax expense exclusively with a view to resale
of, by sale or otherwise, together Non-current asset or disposal Costs to sell include incremental costs
as a group in a single transaction, group of which the owners of the directly attributable to the disposal of
and liabilities directly associated entity are committed to distribute an asset, excluding finance costs and
with those assets that will be to the owners income tax expense
transferred in the transaction
EXHIBIT 15.1 Overview of terms used in HKFRS 5
Refer to Chapter 27 for discussion of current assets.
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15.1.3 Classification of Non-current Assets (or Disposal Groups) as Held
for Sale or as Held for Distribution to Owners
HKFRS 5 requires certain assets or disposal groups (see Exhibit 15.1) to be classified as held
for sale or distribution to owners. Such classification has accounting implications, including
for measurement, presentation and disclosure. Before considering those implications, it is
necessary to understand under what circumstances such a classification is made and when it is
to be made.
HKFRS 5 employs strict criteria for non-current assets to be classified as held for sale or
distribution, which is discussed in the following sections.
An entity classifies a non-current asset or disposal group as held for sale if its carrying
HKFRS amount will be recovered principally through a sale transaction rather than through continuing
5.6 use. The non-current asset (or disposal group) is first classified as held for sale on the date at
which the criteria below are met.
To satisfy the requirements for classifying a non-current asset (or disposal group) as held
for sale, the asset or disposal group must be:
• Available for immediate sale in its present condition subject only to terms that are usual
and customary for sales of such assets or disposal groups; and
HKFRS
5.7 • Highly probable of being sold.
15.1.3.1 Available for Immediate Sale in Present Condition (Criterion 1)
Determining whether a non-current asset (or disposal group) meets the requirement to be
available for immediate sale in its present condition can require judgement. The criterion is met
if the asset could be placed on the market and that any attendant terms and conditions for the
sale would be usual for the asset or disposal group in question.
Illustrative Example 1
Due to increasing competition in the supermarket retail industry, during March 20X8,
Star Provider has begun the process to sell its supermarket chain. Star Provider has
supply contracts with wholesalers throughout the region that have varying contract
lengths, ending from 20Y1 to 20Y4. The supply contracts will be transferred to the
purchaser of the supermarket chain and will not affect the timing of the sale. A question
arises as to whether those contracts render the supermarket chain not ‘available for
immediate sale in its present condition’.
The supermarket chain is available for sale in its present condition providing the
contracts with wholesalers can be transferred to the purchaser and do not involve
resolution of disputes or other problematic issues that must be resolved before the sale
can take place.
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Illustrative Example 2
Silo Limited (Silo), a property investment company, purchased a hotel in Hong Kong with
a view to renovate the internal rooms of the building and subsequently sell it.
The purpose of the acquisition by Silo is to renovate the hotel, thereby increasing its
sales price prior to selling to a third party. The intention of Silo is to sell the hotel only
after the renovations are complete. The delay in the timing of the transfer of the hotel
is imposed by Silo and provides evidence that the property is unavailable for immediate
sale. The available for immediate sale criteria would only be met after the renovations
are complete.
15.1.3.2 Highly Probable (Criterion 2)
HKFRS 5 defines highly probable as ‘significantly more likely than probable’, and it defines
probable as ‘more likely than not’. The standard specifies criteria for determining when a sale
is highly probable.
In particular, HKFRS 5 requires that for a sale to be highly probable:
• The appropriate level of management must be committed to a plan to sell the asset
(or disposal group);
• An active programme to locate a buyer and complete the plan must have been initiated;
• The asset (or disposal group) must be actively marketed for sale at a price that is
reasonable in relation to its current fair value;
• The sale should be expected to qualify for recognition as a completed sale within one
year from the date of classification; and
HKFRS • Actions required to complete the plan should indicate that significant changes to the
5.8 plan will unlikely be made or that the plan will be withdrawn.
Furthermore, HKFRS 5 states that 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.
When an entity commits to a sale plan that involves the loss of control of a subsidiary, it
classifies the assets and liabilities of that subsidiary as held for sale when the above criteria are
HKFRS met regardless of whether the entity will maintain a non-controlling interest in the former
5.8A subsidiary following the sale.
Illustrative Example 3
The board of directors (board) of Star Provider met on 6 March 20X8 and discussed
a proposal from the Managing Director and CEO to sell the supermarket chain. The
proposal included an indicative sales price reflective of the fair value of the supermarket
chain and it detailed the programme to locate a purchaser and complete the sale. The
board of Star Provider approved the proposal and programme to sell the supermarket
chain and initiated the programme immediately, including appointing a broker. Seeking
shareholders’ approval was unnecessary.
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Illustrative Example 3 (continued)
On average, comparable sales within the region are completed 10 months after being
placed on the market.
Management of Star Provider concluded that the supermarket chain was available for
immediate sale in its present condition (refer to the previous illustrative example), and the
sale was highly probable because the appropriate criteria were met:
• The board had approved the plan to sell the supermarket chain;
• The plan to locate a buyer had been initiated;
• The supermarket chain had been priced at an amount that was reflective of
fair value;
• Comparable sales were completed within 10 months; and
• No evidence existed to suggest the plan would change significantly or would be
withdrawn.
Accordingly, Star Provider classified the supermarket chain as held for sale as of
6 March 20X8.
To be classified as held for sale, an asset (or disposal group) must be expected to sell within
one year from the date of classification; however, circumstances may cause the period to
complete the sale to extend beyond one year. This can include an asset (or disposal group) to
continue to be classified as held for sale, provided the delay is due to events or circumstances
HKFRS outside of the entity’s control and sufficient evidence exists that the entity remains committed
5.9 to the sale. The exception to the one-year requirement applies to the following situations:
• On the date an entity commits itself to a plan to sell a non-current asset (or disposal
group), it can reasonably expect that others (not a buyer) will impose conditions on
the transfer of the asset (or disposal group) that will extend the period required to
complete the sale, and:
°° actions necessary to respond to those conditions cannot be initiated until after a
firm purchase commitment is obtained. (A firm purchase commitment is defined as
an agreement with an unrelated party, binding on both parties and usually legally
enforceable, that (a) specifies all significant terms, including the price and timing of
HKFRS the transactions, and (b) includes a disincentive for non-performance sufficiently
5.App A large to make performance highly probable); and
°° a firm purchase commitment is highly probable within one year.
• An entity obtains a firm purchase commitment and, as a result, a buyer or others
unexpectedly impose conditions on the transfer of a non-current asset (or disposal
group) previously classified as held for sale that will extend the period required to
complete the sale, and:
°° timely actions necessary to respond to the conditions have been taken; and
°° a favourable resolution of the delaying factors is expected.
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• During the initial one-year period, circumstances arise that were previously considered
unlikely, and as a result, a non-current asset (or disposal group) previously classified as
held for sale is not sold by the end of that period, and:
°° during the initial one-year period, the entity takes action necessary to respond to
the change in circumstances;
°° the non-current asset (or disposal group) is being actively marketed at a price that is
reasonable, given the change in circumstances; and
HKFRS
5.B1(a)
°° the ‘available for immediate sale’ and ‘highly probable’ criteria are met.
Illustrative Example 4
As of 31 December 20X8, Star Provider has yet to find a buyer for a telecommunications
tower that had met the criteria to be classified as held for sale during the year 20X7.
Though management remains committed to the sale, the market for the specific type
of tower has declined because of the government requiring antennas of the kind
used in Star Provider’s tower to be replaced and upgraded. To position the tower for
sale, during October 20X8, Star Provider replaced the tower’s main antenna to meet
the government’s requirements. Star Provider updated the marketed price to reflect
movements in the market value of telecommunications towers equipped with the
same antenna.
Management of Star Provider concluded that the telecommunications tower should
continue to be classified as held for sale as of 31 December 20X8. Though the time
expected to complete the sale extends beyond one year since its initial classification as
HKFRS
held for sale, the delay was due to unforeseen circumstances and Star Provider has shown
5 para B1(c)(i) continued commitment to the sale by responding to the government’s requirements by
HKFRS replacing the antenna to maintain its saleability. Furthermore, Star Provider has updated
5 para B1(c)(ii)
HKFRS
the marketed price to reflect the market of such telecommunications towers. Criteria 1 and
5 para B1(c)(iii) 2 remain met.
15.1.3.3 Acquisition of a Non-current Asset with a View to Sell
An entity that acquires a non-current asset (or disposal group) exclusively with a view to selling
it must classify the non-current asset (or disposal group) as held for sale only if:
• The sale is expected to qualify for recognition as a completed sale within one year from
the date of classification; and
HKFRS • If not already met, the ‘available for immediate sale’ and/or the remaining ‘highly
5.11 probable’ criteria will be met within a short period (usually less than three months).
The exception provided for non-current assets acquired with a view to selling is to account
for the impracticality of meeting the criteria on acquisition of the asset. For example, it would
be uncommon for an entity to have a detailed selling plan for an asset on the day it obtains
control of the asset. Such assets may be purchased speculatively (to sell for a profit), or they
may be purchased along with other assets that are the prime purpose of the acquisition.
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15.1.3.4 Meeting the Held for Sale Criteria After the End of a Reporting Period
Where an entity’s non-current asset (or disposal group) meets the ‘available for immediate
sale’ and ‘highly probable’ criteria after the end of the reporting period but before the financial
statements are authorised for issue, the entity does not classify the asset (or disposal group)
as held for sale (see Chapter 17). However, in those circumstances, the entity is required to
make additional disclosures in relation to the non-current asset, a description of the facts
and circumstances of the sale and the reportable segment in which the non-current asset
(or disposal group) is presented in accordance with HKFRS 8 Operating Segments.
15.1.3.5 Assets Held for Distribution to Owners
Instead of deciding to sell an asset, an entity might decide to distribute the asset to its owners.
The requirements are similar. For example, 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. This is sometimes called an in-specie distribution.
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.
For the distribution to be highly probable:
• Actions to complete the distribution must have been initiated; and
• The distribution should be expected to be completed within one year from the date of
classification.
Actions required to complete the distribution should indicate that significant changes to the
distribution will unlikely be made or the distribution will be withdrawn.
HKFRS The probability of shareholders’ approval (if required in the jurisdiction) should be
5.12A considered as part of the assessment of whether the distribution is highly probable.
15.1.3.6 Assets to Be Abandoned
It might be the case that an entity intends to abandon an asset rather than sell or distribute it.
Where an entity intends to abandon an asset (or disposal group), the entity does not
classify the asset (or disposal group) as held for sale. This is because the remaining carrying
amount of the asset is to be recovered principally through its continuing use rather than by
sale. Assets that are to be abandoned include those assets that must be used to the end of
their economic life and assets that must be closed rather than sold. Where a disposal group
to be abandoned meets the definition of a discontinued operation, an entity must present the
results and cash flows as discontinued operations at the date on which it ceases to be used
(refer to Section 15.3.1.3).
The following decision tree (Exhibit 15.2) summarises the classification requirements
of HKFRS 5.
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Asset or disposal group to be Abandoned
sold or abandoned?
Sold
Available for immediate sale in No
present condition?
Yes
Sale highly probable?
• Management committed
to the plan
• Active programme to locate No Acquired exclusively with No
a buyer a view to sell?
• Marketed at fair value
• Significant changes to plan
Yes
unlikely
Yes Highly probable that criteria No
Yes will be met within three
months of purchase?
Sale expected within one year?
No
Yes
No Criteria met before No
Criteria met before end of
authorisation of
year?
financial statements?
Yes Yes
Classify as held for sale, and
Do not classify as held for sale,
remeasure and disclose in Do not classify as held for sale
provide disclosures
accordance with HKFRS 5
EXHIBIT 15.2 HKFRS 5 classification decision tree
Knowledge Check Questions
Question 1
In relation to the scope of HKFRS 5, identify to which of the following would the
measurement requirements of HKFRS 5 apply.
A Property, plant and equipment
B Deferred tax assets
C Assets arising from employee benefits
D Financial assets within the scope of HKFRS 9 Financial Instruments
Question 2
Identify a criterion that must be met for a non-current asset to be classified as
held for sale.
A Be available for sale within 12 months and the sale must be highly probable
B Be available for immediate sale in its present condition subject only to terms that are
usual and customary for sales of such assets and the sale must be highly probable
C Be available for immediate sale in its present condition and the sale must be significantly
likely to occur
D Be likely to occur within 12 months
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Knowledge Check Questions (continued)
Question 3
Diggers & Ploughs Limited (Diggers & Ploughs) is a manufacturer of farming equipment
with production facilities located in China. As of 31 October 20X5, the company was
committed to selling a machine and met the criteria to be classified as held for sale in
accordance with HKFRS 5. On 15 August 20X6, the company has obtained a firm purchase
commitment for the machine; however, due to local government regulations, the sale
could not be finalised until 15 January 20X7. The company was previously unaware of the
government regulations imposed on the sale but began taking the necessary steps to
satisfy the requirements.
Determine how Diggers & Ploughs should classify the machine in its 31 December 20X6
financial statements.
Question 4
Tanker Limited (Tanker) is a manufacturer of custom-made dining tables. Tanker intends to
sell its manufacturing facility but not its operations. Tanker’s intention is to sell the facility
after it ceases operations and has completed all existing customer orders.
Determine whether the manufacturing facility would meet the available for sale criteria.
1 5 . 2 MEASUREMENT OF NON-CURRENT ASSETS
(OR DISPOSAL GROUPS) CLASSIFIED
AS HELD FOR SALE
Once an asset or disposal group is classified as held for sale or distribution, it is subject to the
specific measurement requirements of HKFRS 5 as set out in the following section.
15.2.1 Measurement of a Non-current Asset (or Disposal Group)
15.2.1.1 Assets or Disposal Groups Held for Sale
HKFRS An entity measures non-current assets (or disposal groups) classified as held for sale at the
5.15 lower of carrying amount and fair value less costs to sell.
When considering the carrying amount of a non-current asset, HKAS 16 Property, Plant and
Equipment requires that the useful life and residual values of property, plant and equipment
to be kept current, and HKAS 36 Impairment of Assets requires assets to be impaired if their
carrying amount exceeds their recoverable amount.
HKFRS 5 introduces a new basis of measurement when the carrying amount determined
under those standards exceeds fair value less costs to sell for non-current asset (or disposal
group) held for sale.
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Fair value is defined as the price that would be received to sell an asset or paid to transfer
HKFRS a liability in an orderly transaction between market participants at the measurement date
5.App A (see Chapter 4).
Costs to sell is defined as the incremental costs directly attributable to the disposal of an
HKFRS asset (or disposal group), excluding finance costs and income tax expense, for example, due
5.App A diligence costs and commissions. Costs to sell are measured at present value when the sale is
expected to occur beyond one year, for example, because of a delay due to events outside the
entity’s control. The increase in the present value of costs to sell arising from the passage of
HKFRS time (also known as the ‘unwinding of the discount’) is recognised in profit or loss as a
5.17 financing cost.
An entity shall not depreciate (or amortise) a non-current asset while it is being classified as
held for sale or while it is part of a disposal group classified as held for sale. Interest and other
HKFRS expenses attributable to the liabilities of a disposal group classified as held for sale shall
5.25 continue to be recognised.
15.2.1.2 Assets or Disposal Groups Held for Distribution
HKFRS An entity measures non-current assets (or disposal groups) classified as held for distribution to
5.15A owners at the lower of the carrying amount and fair value less costs to distribute.
Costs to distribute include costs that are directly attributable to the distribution, excluding
HKFRS
5 para 15A, finance costs and income tax expense, for example, legal costs and other costs associated with
footnote transferring an asset.
As previously noted, the subsequent accounting for assets or disposal groups held for
distribution is the same as the accounting for assets or disposal groups held for sale.
15.2.1.3 Other Issues
Assets (or Disposal Groups) Acquired with a View to Sell
Where an entity acquires an asset (or disposal group) exclusively with a view to sell (refer to
Section 15.1.3.2), the asset (or disposal group) is measured at the lower of the carrying amount,
for example, cost, and fair value less costs to sell. Therefore, when such assets are acquired
through a business combination, they are measured at fair value less costs to sell.
Other Assets within a Disposal Group
The carrying amount of an asset within a disposal group not subject to the measurement
requirements of HKFRS 5 because the asset is within the scope of a specific standard is
HKFRS remeasured in accordance with its applicable standard before the fair value less costs to sell or
5.19 distribute of the disposal group is remeasured. For example, as noted in Section 15.1.1, the
measurement requirements of HKFRS 5 do not apply to investment properties measured using
the fair value model. Accordingly, where such investment property is included within a disposal
group, it is remeasured in accordance with HKAS 40 Investment Property before the fair value
less costs to sell of the disposal group is remeasured.
15.2.2 Recognition of Impairment Losses and Reversals
15.2.2.1 Impairment Losses–Individual Assets Classified as Held for Sale
Entities are required to recognise an impairment loss for any initial or subsequent write-down
of an asset to fair value less costs to sell or distribute.
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Illustrative Example 5
Prior to the first classifying as held for sale in 20X7, Star Provider’s telecommunications
tower had a carrying amount of HK$2,500,000. In its 20X7 financial statements,
the telecommunications tower was measured at fair value less costs to sell, being
HK$2.475 million, and an impairment loss of HK$25,000 (HK$2.5 million − HK$2.475 million)
was recognised in profit or loss for the year ended 31 December 20X7. The following journal
entry was prepared:
Debit Credit
HK$ HK$
Impairment loss 25,000
Accumulated impairment – telecommunication tower 25,000
From the date of classifying the telecommunication tower as held for sale, Star
Provider has ceased depreciation for the item. This would be the case even if the tower
were recognised at carrying amount rather than at fair value less costs to sell.
As of 31 December 20X8, the tower remains classified as held for sale (refer to
Illustrative Example 4 in Section 15.1.3.2). Star Provider’s management has determined
that the fair value of the tower is HK$2.55 million, and HK$100,000 in marketing costs
would be required to make the sale.
The telecommunications tower is carried at the remeasured fair value less costs
to sell amount (HK$2.45 million) as it is lower than the previous carrying amount
(HK$2.475 million). Accordingly, on 31 December 20X8, Star Provider further recognised an
impairment loss of HK$25,000 relating to the telecommunication tower (HK$2.475 million −
HK$2.45 million). The telecommunication tower would then be reported at HK$2.45 million
on Star Provider’s statement of financial position as of 31 December 20X8.
15.2.2.2 Impairment Losses–Disposal Groups Classified as Held for Sale
The accounting for impairment losses on disposal groups classified as held for sale is more
complex when compared to individual assets classified as held for sale.
Entities are required to recognise an impairment loss for any initial or subsequent
write-down of a disposal group to fair value less costs to sell or distribute, but only to the
extent it is not already recognised in accordance with other standards.
In practice, this results in the following three steps being applied when accounting for
disposal groups:
1. Remeasure the held for sale disposal group assets that are not within the scope of the
measurement requirements of HKFRS 5 in accordance with their specific measurement
requirements;
2. Add those remeasured assets from Step 1 to the carrying amounts of the disposal
group assets that are within the measurement scope of HKFRS 5; and
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3. Determine the fair value less costs to sell or distribute of the disposal group, and
compare it with the total carrying amount of the held for sale or distribution disposal
group assets as determined in Step 2.
Key Learning Point
Non-current assets included in a disposal group not within the measurement scope of
HKFRS 5 must be remeasured in accordance with the applicable standard prior to comparing
the disposal group’s carrying amount to its fair value less costs to sell or distribute.
When an entity recognises an impairment loss for a disposal group, it allocates the
impairment loss to the carrying amount of the non-current assets within the measurement
scope of HKFRS 5. Consistent with HKAS 36 Impairment of Assets (see Chapter 14), the entity
allocates the impairment loss to any goodwill within the disposal group and then to the other
assets within the disposal group on a pro rata basis.
Illustrative Example 6
Star Provider has determined its supermarket chain is a disposal group that is classified
as held for sale. As of 31 March 20X8, the fair value less costs to sell of the assets
within the disposal group was determined to be HK$4,300,000. The carrying amount
of the assets within the disposal group was HK$6,400,000, which consisted of the
following assets:
Asset Carrying amount
HK$
Goodwill 300,000
Other intangibles 1,700,000
Property, plant and equipment 3,100,000
Cash 800,000
Trade receivables 500,000
6,400,000
Consistent with HKFRS 5, Star Provider has identified that:
1. The disposal group is required to be written down by HK$2.1 million as the carrying
amount exceeds the fair value less costs to sell (HK$6.4 million − HK$4.3 million);
2. The write-down can only be allocated to assets within the measurement scope
of HKFRS 5. Accordingly, the write-down will not be allocated to cash and trade
receivables as financial assets within the scope of HKFRS 9 are excluded from the
measurement scope of HKFRS 5; and
3. The write-down is allocated to the goodwill (HK$300,000) and then on a pro-rata
basis to the other disposal group non-current assets within the measurement
scope of HKFRS 5 (HK$1.8 million).
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Illustrative Example 6 (continued)
The write-down is allocated to the assets within the disposal group as follows:
Asset Pre-write-down Write-down Post-write-down
HK$) HK$ HK$
Goodwill 300,000 (300,000) –
Other intangibles 1,700,000 (637,500) a 1,062,500
Property, plant and equipment 3,100,000 (1,162,500)b 1,937,500
Cash 800,000 – 800,000
Trade receivables 500,000 – 500,000
6,400,000 (2,100,000) 4,300,000
a
1,800,000 × (1,700,000/(3,100,000 + 1,700,000)) = 637,500
b
1,800,000 × (3,100,000/(3,100,000 + 1,700,000)) = 1,162,500
15.2.2.3 Reversals–Individual Assets Classified as Held for Sale
An entity recognises a gain for any subsequent increase in fair value less costs to sell of an
asset, but not in excess of the cumulative impairment loss that has been recognised either in
accordance with HKFRS 5 or previously in accordance with HKAS 36 Impairment of Assets.
Illustrative Example 7
Minerals Extractor Limited (Minerals Extractor) is a mining company operating in remote
Western Australia.
During 20X7, a significant downturn in the economy resulted in Minerals Extractor
recognising an impairment loss on its excavator in accordance with HKAS 36, amounting to
HK$700,000. The excavator’s carrying amount immediately following the impairment was
equal to HK$500,000.
Subsequently, during 20X8, Minerals Extractor committed to sell the excavator and
was in the process of identifying a purchaser able to relocate and repurpose the excavator.
As of 30 June 20X8, the excavator was first classified as held for sale with a fair value less
costs to sell equal to HK$450,000. Assuming the carrying amount of the excavator at this
time was HK$480,000, this would result in a further impairment loss of HK$30,000.
In October 20X8, a decision by the government to reduce export tariffs on minerals and
a turnaround in the economy resulted in a significant increase in demand from remaining
mining companies in the region for the excavator. As of 31 October 20X8, the excavator’s
fair value less costs to sell was equal to HK$1.35 million. Minerals Extractor remained
committed to the sale.
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Illustrative Example 7 (continued)
Minerals Extractor recognises an impairment reversal, but only to the extent of the
cumulative impairment recognised in accordance with HKFRS 5 and HKAS 36. Therefore,
an impairment reversal of HK$730,000 is recognised, meaning a reversal of the HK$30,000
impairment and HK$700,000 impairment recognised in accordance with HKFRS 5 and
HKAS 36, respectively. Following the impairment reversal, the carrying amount of the
excavator is equal to the HK$1.18 million.
15.2.2.4 Reversals–Disposal Groups Classified as Held for Sale
An entity recognises a gain for any subsequent increase in fair value less costs to sell or
distribute of a disposal group:
• To the extent it has not been recognised for assets that are included in the disposal
group but not within the measurement scope of HKFRS 5; but
• Not in excess of the cumulative impairment loss that has been recognised, either in
accordance with HKFRS 5 or previously in accordance with HKAS 36 on the non-current
assets within the scope of the measurement requirements of HKFRS 5. This is because
the non-current asset is measured at the lower of its carrying amount and fair value
less costs to sell.
Illustrative Example 8
Star Provider subsequently determined that, as of 31 December 20X8, the fair value less
costs to sell of the assets within the disposal group was equal to HK$6,200,000. Following
the impairment calculated as of 31 March 20X8, the carrying amount of the assets within
the disposal group was HK$4,300,000 (refer to Illustrative Example 7).
Consistent with HKFRS 5, Star Provider has identified that:
1. The company is required to compute an impairment reversal of HK$1.9 million
(HK$6.2 million − HK$4.3 million);
2. The reversal can only be allocated to assets within the measurement scope
of HKFRS 5. Accordingly, the reversal will not be allocated to cash and trade
receivables as financial assets within the scope of HKFRS 9 are excluded from the
measurement scope of HKFRS 5;
3. HKAS 36 does not permit the reversal of impairment of goodwill; and
4. The reversal is allocated on a pro-rata basis to the other disposal group
non-current assets within the measurement scope of HKFRS 5 but only to the
extent of the cumulative impairment loss previously recognised (HK$1.8 million).
Accordingly, the excess HK$100,000 (HK$1.9 million − HK$1.8 million) will not be
allocated to any assets within the disposal group.
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Illustrative Example 8 (continued)
Asset Pre-write- Write-down Post-write- Reversal on Post-
down on 31 March down on 31 December reversal on
31 March 31 December
HK$ HK$ HK$ HK$ HK$
Goodwill 300,000 (300,000) – – –
Other 1,700,000 (637,500) 1,062,500 637,500 1,700,000
intangibles
Property, plant 3,100,000 (1,162,500) 1,937,500 1,162,500 3,100,000
and equipment
Cash 800,000 – 800,000 – 800,000
Trade 500,000 – 500,000 – 500,000
receivables
6,400,000 (2,100,000) 4,300,000 1,800,000 6,100,000
Key Learning Point
A gain on the subsequent remeasurement of a non-current asset classified as held for sale
or distribution within the measurement scope of HKFRS 5 must be recognised only to the
extent of the cumulative impairment loss.
15.2.3 Changes to a Plan of Sale or to a Plan of Distribution to Owners
Where an asset (or disposal group) no longer meets the criteria to be classified as held for sale
or distribution, the asset (or disposal group) must no longer be classified as such. Such an asset
(or disposal group) must be measured at the lower of:
• The carrying amount of the asset immediately prior to it being classified as held for sale
or distribution, adjusted for any depreciation, amortisation or revaluations that would
have been recognised had the asset never been so classified; and
HKFRS
5.27 • Its recoverable amount at the date of the decision not to sell or distribute.
The adjustment to the carrying amount shall be recognised in profit or loss unless the
HKFRS non-current asset was revalued prior to being classified as held for sale or distribution in which
5.28 case the adjustment is accounted for as a revaluation increase or decrease.
HKFRS The reason for the measurement requirement for assets that cease to be classified as held
5.BC51 for sale or distribution is to be consistent with the requirements of HKAS 36 (see Chapter 14).
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Illustrative Example 9
Powering You Limited (Powering You) provides power to remote locations throughout
Asia. The company purchased a generator on 1 January 20X1 at a cost of HK$3.5 million.
The generator had an expected useful life of 10 years and nil residual value and was
to be depreciated on a straight-line basis. As of 1 January 20X4, Powering You was
committed to the sale of the generator and met the criteria for it to be classified as held
for sale in accordance with HKFRS 5. The generator was carried at fair value less costs to
sell, being HK$2.3 million.
On 1 January 20X6, management made the decision not to sell the generator, and
therefore, the generator no longer met the criteria to be classified as held for sale.
At the time, the fair value less costs to sell and recoverable amount of the generator was
HK$2.1 million.
As the generator no longer met the criteria to be classified as held for sale, it was
measured at the lower of: (1) the carrying amount had the asset never been classified as
held for sale; and (2) the recoverable amount as of the date of the decision not to sell.
The generator is, therefore, measured at HK$1.75 million (HK$3.5 million less
accumulated depreciation of HK$1.75 million*), being its carrying amount as if the asset
had never been classified as held for sale, as this is lower than the recoverable amount of
HK$2.1 million.
* HK$1.75 million = 5 years * (HK$3.5 million/10 years)
Debit Credit
HK$ HK$
Impairment loss 350,000
Accumulated impairment: generator 350,000
To recognise the impairment loss on the revaluation to the carrying amount
(2,100,000 − 1,750,000)
As the generator is no longer classified as held for sale, it is reclassified to general
equipment and depreciation recommences.
15.2.3.1 Reclassification
In some cases, an entity may change from a plan to sell an asset (or disposal group) to a
plan to distribute the asset (or disposal group) to its owners (or vice versa). For example, an
entity might be unable to find a buyer for an asset and might, therefore, distribute the asset
(or disposal group) to the entity’s owners. Where an entity reclassifies an asset (or disposal
group) directly from being held for sale (held for distribution) to held for distribution (held for
sale), the entity must:
• Measure the non-current asset (or disposal group) in accordance with the
measurement requirements for the new classification, and recognise the reduction
or the increase in the new measurement consistent with the requirements in
Section 15.2.2; and not
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• Change the date of the initial classification. In many cases, the events that led to the
reclassification may have also resulted in the time since the initial classification
extending beyond one year. This does not preclude an entity from continuing to
classify the non-current asset (or disposal group) as held for sale or distribution,
HKFRS provided the delay was caused by events or circumstances outside of the entity’s
5.26A control (refer to Section 15.1.3.2).
Knowledge Check Questions
Question 5
A used car dealership owns non-current assets within a disposal group that are first
classified as held for sale in accordance with HKFRS 5 as of 31 December 20X9. At the
date of classification, the carrying amount of the assets within the disposal group was
HK$11.7 million, which consisted of the following assets:
Asset Carrying amount
HK$
Goodwill 1,700,000
Investment property (before fair value measurement) 3,500,000
Property, plant and equipment 5,200,000
Cash 400,000
Trade receivables 900,000
11,700,000
Investment property is carried at fair value in accordance with HKAS 40. As of
31 December 20X9, an independent valuer determined the fair value of the property
was HK$2.8 million.
The company determined the fair value less costs to sell of the disposal group was
HK$7.8 million.
Calculate the impairment loss to be allocated to the assets within the disposal group.
Question 6
Following from Question 5, as of 30 June 20Y0, management of the used car dealership
determined the fair value less costs to sell of the disposal group was HK$9.4 million. On
the same date, an independent valuer determined that the fair valuer of the investment
property was HK$3.7 million.
Assume no changes have occurred to other balances for the used car dealership.
Calculate the impairment reversal to be allocated to the assets within the disposal
group.
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Knowledge Check Questions (continued)
Question 7
Company X purchased a commercial oven on 1 January 20X3 at a cost of HK$750,000.
The oven had an estimated useful life of 15 years and nil residual value and was to
be depreciated on a straight-line basis. On 1 July 20X5, the oven met the criteria to be
classified as held for sale in accordance with HKFRS 5, with a fair value less costs to sell of
HK$600,000.
On 31 December 20X6, the oven no longer met the criteria to be classified as held
for sale. As of 31 December 20X6, the recoverable amount of the asset was equal to
HK$575,000.
Determine the carrying amount of the asset at in Company X’s 31 December 20X6
financial statements.
A HK$525,000
B HK$600,000
C HK$550,000
D HK$575,000
1 5 . 3 PRESENTATION AND DISCLOSURE
Classification of an asset or disposal group as held for sale or distribution has implications for
measurement and has implications for presentation and disclosure. Indeed, HKFRS 5 not only
specifies presentation and disclosure requirements for assets and disposal groups held for sale
or distribution; it includes presentation and disclosure requirements for what it refers to as
‘discontinued operations’ (relative to continuing operations) and sold assets or disposal groups.
In particular, HKFRS 5 requires entities to present and disclose information that enables users
of the financial statements to evaluate the financial effects of disposals of non-current assets
HKFRS (or disposal groups), whether classified as held for sale or distribution prior to sale, and
5.30 ‘discontinued operations’. Such information might also assist users in predicting the future
maintainable earnings of an entity.
15.3.1 Presenting Discontinued Operations
Discontinued operations differ from assets or disposal groups held for sale or distribution
although the concepts are linked. For example, a discontinued operation may also be a
component of an entity that is classified as held for sale or distribution. HKFRS 5 prescribes
presentation and disclosure requirements for discontinued operations and not for
measurements (as is the case for assets or disposal groups classified as held for sale or
distribution).
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Entities are required to present discontinued operations separately from continuing
operations in an entity’s statement of profit or loss and other comprehensive income and
prepare specific disclosures. First, we need to understand what a discontinued operation is.
To do that, we need to know what a component of an entity is because a component of an
entity is a critical part of the definition of a discontinued operation.
15.3.1.1 Component of an Entity
HKFRS A component of an entity comprises operations and cash flows that can be clearly
5.App A distinguished, operationally and for financial reporting purposes, from the rest of the entity.
HKFRS HKFRS 5 clarifies that a component of an entity will have been a ‘cash-generating unit’ (CGU) or
5.31 a group of CGUs while being held for use. A cash-generating unit is the smallest identifiable
group of assets that generates cash inflows that are largely independent of the cash inflows
from other assets or groups of assets.
15.3.1.2 Classification as a Discontinued Operation
A discontinued operation is a component of an entity that has been disposed of or is
classified as held for sale or distribution and:
• Represents a separate major line of business or geographical area of operations;
• Is part of a single co-ordinated plan to dispose of a separate major line of business or
geographical area of operations; or
HKFRS
5.App A • Is a subsidiary acquired exclusively with a view to resale.
The definition does not require the component of the entity to have been disposed of
yet; merely being classified as held for sale is enough. Although ‘discontinuing operation’
might more accurately describe such circumstances, HKFRS 5 refers to them as ‘discontinued
operations’.
Determining whether a component of an entity represents a discontinued operation often
requires judgement. Not every cessation or planned cessation of an activity will represent a
discontinued operation.
Illustrative Example 10
During March 20X8, Star Provider began planning for the sale of its supermarket chain.
The company’s supermarket chain operates independently of its other retail businesses
and represents a separate CGU.
In determining whether the supermarket chain should be classified as a discontinued
operation, Star Provider considers the requirements of HKFRS 5 as follows:
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Illustrative Example 10 (continued)
Requirement Application
1. Is the supermarket chain a component of Yes – Because the supermarket chain is a CGU, it
Star Provider? represents a component of Star Provider.
2. Has the supermarket chain been disposed Yes – The supermarket chain is classified as
of, or is it classified as held for sale? held for sale (refer to Illustrative Example in
Section 15.1.3.2).
3. Does the supermarket chain meet any of Yes – The supermarket chain represents a
the following criteria? separate major line of Star Provider’s business.
(a) Does the supermarket chain If, instead, Star Provider had planned to sell
represent a separate major line of one retail supermarket outlet located in Hong
business or geographical area of Kong in a chain of supermarket outlets in the
operations? area, this would not constitute a discontinued
operation. Even if the supermarket in question
(b) Is the supermarket chain part of a
was determined to be a component of the entity,
single co-ordinated plan to dispose of
Star Provider would not be discontinuing a major
a separate major line of business or
line of business (i.e. Star Provider will continue
geographical area of operations?
operating in the retail supermarket business)
(c) Is the supermarket chain a subsidiary or discontinuing operations in a geographical
acquired exclusively with a view area (i.e. other retail supermarkets will remain in
to resale? Hong Kong).
As the supermarket chain meets the definition of a discontinued operation, Star
Provider must prepare additional disclosures related to the discontinued operation and
present the results of the activities separately from the results of its continuing operations.
Illustrative Example 11
Star Provider provides retail electricity and gas services to customers. The electricity and
gas retail business represents a CGU of Star Provider.
Due to increased contestability in the market and uptake of residential solar and
battery installations, Star Provider’s customer base has deteriorated. During 20X9,
management of Star Provider made the decision to abandon the business on completion
of all existing customer contracts.
Star Provider does not classify the electricity and gas retail business as held for sale
because the carrying amount of the assets within the group will be recovered principally
through the continuing use of the assets. However, the business is a discontinued
operation because it is a component of an entity (by way of being a CGU) and represents a
separate major line of business.
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15.3.1.3 Disclosure
The disclosures required for discontinued operations are presented in the financial statements
or in the notes to the financial statements (Exhibit 15.3). Certain disclosures are not required
for disposal groups that are newly acquired subsidiaries that meet the criteria as held for sale
on acquisition.
Para. Disclosure Financial statements
or Notes
33(a)(i) Single amount comprising the post-tax profit or loss of Financial statements
discontinued operations
33(a)(ii) Single amount comprising the post-tax gain or loss Financial statements
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
33(b)a Analysis of the disclosure required by para. 33(a) into: Choice
• The revenue, expenses and pre-tax profit or loss of
discontinued operations;
• The 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; and
• The related income tax consequences separately for
each of the above.
33(c)a Net cash flows attributable to the operating, investing and Choice
financing activities of discontinued operations
33(d) Amount of income from continuing operations and Choice
from discontinued operations attributable to owners of
the parent
34 Re-present disclosures required by para. 33 for prior
periods that are presented
35 Adjustments in the current period to amounts previously
presented in discontinued operations directly related to the
disposal of a discontinued operation in a prior period shall
be classified separately in discontinued operations
36 If an entity ceases to classify a component of an entity as
held for sale, the results of operations of the component
previously presented in discontinued operations in
accordance with paras. 33–35 shall be reclassified and
included in income from continuing operations for all
periods presented
a
Disclosure is not required for newly acquired subsidiaries held for sale on acquisition.
EXHIBIT 15.3 Disclosures for discontinued operations
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Illustrative Example 12
Star Provider made the following disclosures in relation to the discontinued operation in
its statement of comprehensive income for the year ended 31 December 20X8.
Star Provider Limited
Statement of Profit or Loss and Other Comprehensive Income
(Year ended 31 December 20X8)
20X8 20X7
HK$ HK$ HKFRS 5
Continuing operations
Revenue 29,300,000 29,100,000
Cost of sales (23,400,000) (24,400,000)
Gross profit 5,900,000 4,700,000
Other income 1,200,000 1,100,000
Administrative expenses (1,500,000) (1,600,000)
Other expenses (500,000) (400,000)
Finance costs (700,000) (500,000)
Profit before tax 4,400,000 3,300,000
Income tax expense (1,400,000) (1,200,000)
Profit from continuing operations 3,000,000 2,100,000
Discontinued operations
Loss for the period from discontinued (2,400,000) (1,900,000) Para 33(a)(i)
operations
Profit for the period 600,000 200,000
Profit attributable to
owners of the parent
Profit from continuing operations 2,300,000 1,600,000 Para 33(d)
Loss from discontinued operations (1,800,000) (1,500,000) Para 33(d)
Profit attributable to owners of the parent 500,000 100,000
Non-controlling interests
Profit from continuing operations 700,000 500,000
Loss from discontinued operations (600,000) (400,000)
Profit attributable to non-
controlling interests 100,000 100,000
Star Provider elects to present the detailed analysis of the post-tax loss from discontinued
operations (as required by paragraph 33(b) in the notes to the financial statements.
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15.3.2 Gains or Losses Relating to Continuing Operations
Any gain or loss on the remeasurement of a non-current asset (or disposal group) classified as
HKFRS held for sale or distribution that does not meet the definition of a discontinued operation shall
5.37 be included in profit or loss from continuing operations.
15.3.3 Presentation of a Non-current Asset or Disposal Group Classified
as Held for Sale or Distribution
Entities are required to present non-current assets classified as held for sale or distribution and
assets that are part of a disposal group classified as held for sale or distribution separately
from other assets in the statement of financial position. Also, the liabilities of a disposal group
classified as held for sale or distribution are required to be presented separately from other
liabilities in the statement of financial position. Separate presentation of such assets and
liabilities provides relevant information to users of financial statements. Furthermore, users
HKFRS can identify those assets that are not being depreciated. The assets and liabilities shall not
5.38 be offset.
The major classes of assets and liabilities classified as held for sale or distribution are
HKFRS
required to be separately disclosed in the statement of financial position or in the notes. This
5 para. 39 disclosure is not required for a disposal group that is a newly acquired subsidiary that meets
HKFRS the criteria to be classified as held for sale on acquisition because it could involve the entity
15.BC55 having to obtain more information about the subsidiary.
Furthermore, entities are required to present separately any cumulative income or expense
recognised in other comprehensive income relating to a non-current asset (or disposal group)
classified as held for sale or distribution.
HKFRS When a non-current asset (or disposal group) is initially classified as held for sale or
5.40 distribution, an entity does not reclassify or re-present prior periods to reflect the classification.
Illustrative Example 13
As of 31 December 20X8, Star Provider owns the following non-current assets classified
as held for sale:
20X8 20X7
HK$ HK$
Supermarket chain disposal group:
Other intangibles 1,700,000 –
Property, plant and equipment 3,100,000 –
Other non-current assets classified as held for sale:
Telecommunications tower 2,450,000 2,475,000
Office buildings a 1,600,000 –
Landa 2,400,000 –
11,250,000 2,475,000
a
Office buildings and land are not included in prior examples related to Star Provider.
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Illustrative Example 13 (continued)
Below is an extract of Star Provider’s statement of financial position as of
31 December 20X8.
Star Provider
Statement of Financial Position
(As of 31 December 20X8)
20X8 20X7
HK$ HK$
Current assets
Cash 12,400,000 10,200,0000
Receivables 26,800,000 27,400,000
Inventories 14,400,000 13,200,000
53,600,000 50,800,000
Non-current assets
Property, plant and equipment 45,400,000 41,900,000
Intangibles 29,200,000 26,200,000
Deferred tax assets 13,200,000 12,800,000
87,800,000 80,900,000
Non-current assets classified as held for sale 11,250,000 2,475,000
Total assets 152,650,000 134,175,000
As Star Provider does not separately disclose the non-current assets in the statement
of financial position, it must provide a breakdown of the non-current assets in the notes to
the financial statements.
The presentation requirements of HKFRS 5 do not apply retrospectively, and therefore,
the HK$3,000,000 related to the non-current assets of the supermarket chain disposal
group and the HK$4,000,000 related to the office building and land located in Hong Kong
are not re-presented in the comparative period. As the telecommunications tower was
classified as held for sale during 20X7, the comparative amount is disclosed.
Knowledge Check Questions
Question 8
Identify which one of the following does not represent a discontinued operation.
A A component of an entity that has been disposed of or is classified as held for sale and is
a subsidiary acquired exclusively with a view to resale
B A component of an entity that has been disposed of or is classified as held for sale and is
accounted for using the equity method
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Knowledge Check Questions (continued)
C A component of an entity that has been disposed of or is classified as held for sale and
is part of a single co-ordinated plan to dispose of a separate major line of business or
geographical area of operations
D A component of an entity that has been disposed of or is classified as held for sale and
represents a separate major line of business or geographical area of operations
Question 9
Identify which one of the following disclosures is not required for newly acquired
subsidiaries classified as held for sale on acquisition.
A Single amount comprising the post-tax profit or loss of discontinued operations
B Net cash flows attributable to the operating, investing and financing activities of
discontinued operations
C Single amount comprising 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
D Amount of income from continuing operations and from discontinued operations
attributable to owners of the parent
Question 10
All Sorts Manufacturing Limited (All Sorts) is disposing of its farm equipment
manufacturing line of business. The line of business was first classified as held for sale
on 1 April 20X7 and was assessed as being a discontinued operation. As of 31 December
20X7, the discontinued operation consisted of HK$3.4 million in non-current assets and
HK$1,3 million in current liabilities.
Identify and justify two errors relating to HKFRS 5 requirements in the following All
Sorts’ statement of financial position.
All Sorts Manufacturing Limited
Statement of Financial Position
(As of 31 December 20X7)
20X7 20X6
HK$ HK$
Current assets
Cash 5,600,000 10,200,000
Receivables 9,400,000 7,400,000
Prepayments 2,300,000 1,800,000
Contract assets 1,800,000 1,500,000
Inventories 8,500,000 13,200,000
27,600,000 34,100,000
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Knowledge Check Questions (continued)
All Sorts Manufacturing Limited
Statement of Financial Position
(As of 31 December 20X7)
20X7 20X6
HK$ HK$
Non-current assets
Property, plant and equipment 31,400,000 34,400,000
Intangibles 28,200,000 24,200,000
Deferred tax assets 9,200,000 7,600,000
68,800,000 66,200,000
Net non-current assets classified as held for sale 2,100,000 2,100,000
Total assets 98,500,000 102,400,000
Current liabilities
Payables 8,200,000 6,900,000
Contract liabilities 1,300,000 1,100,000
9,500,000 8,000,000
Non-current liabilities
Loans 28,400,000 29,000,000
Lease liabilities 14,200,000 13,500,000
42,600,000 42,500,000
Total liabilities 52,100,000 50,500,000
Net assets 46,400,000 51,900,000
Equity
Share capital 25,000,000 25,000,000
Reserves 9,000,000 8,200,000
Retained earnings 12,400,000 18,700,000
Total equity 46,400,000 51,900,000
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SUMMARY
• HKFRS 5 specifies the accounting for non-current assets and disposal groups classified as held
for sale or distribution to owners and discontinued operations.
• A non-current asset (or disposal group) is classified as held for sale or distribution when its
carrying amount will be recovered principally through a sale or distribution transaction rather
than through continuing use.
• To be classified as held for sale or distribution, the asset (or disposal group) must be available
for immediate sale or distribution in its present condition, subject only to terms that are usual
and customary for sales of such assets (or disposal groups), and the sale or distribution must
be highly probable.
• The following criteria must be met for a sale to be highly probable:
°° High level of management must be committed to the plan to sell the asset;
°° An active programme to locate a buyer and complete the plan must have been initiated;
°° The asset must be actively marketed for sale at a price that is reasonable in relation to its
current fair value;
°° The sale should be expected to be completed within one year; and
°° Actions required to complete the plan should indicate that significant changes to the plan
will not likely be made.
• The following criteria must be met for a distribution to be highly probable:
°° Actions to complete the distribution must have been initiated:
°° The distribution should be expected to be completed within one year; and
°° Actions required to complete the distribution should indicate that it is unlikely that
significant changes to the distribution will be made.
• An asset (or disposal group) classified as held for sale is measured at fair value less
costs to sell.
• An asset (or disposal group) classified as held for distribution to owners is measured at fair
value less costs to distribute.
• When measuring the fair value less costs to sell or distribute of a disposal group, an entity
follows three steps:
1. Remeasure held for sale assets that are not within the measurement scope of HKFRS 5;
2. Add those remeasured assets to the carrying amounts of the assets within the
measurement scope of HKFRS 5; and
3. Determine the fair value less costs to sell or distribute of the disposal group and compare
it with the total carrying amount of the held for sale or distribution assets derived
in Step 2.
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• Where fair value less costs to sell or distribute is below the carrying amount, an impairment
loss is recognised.
• When allocating an impairment loss to a disposal group, an entity first allocates the
impairment to any goodwill within the disposal group.
• When recognising a gain on remeasurement of fair value less costs to sell or distribute
(i.e. a reversal of an impairment), an entity only recognises the gain to the extent of any
previous cumulative impairment loss.
• If an asset (or disposal group) no longer meets the criteria to be classified as held for sale or
distribution, the asset is remeasured to the lower of:
°° The carrying amount had the asset never been classified as held for sale in the first
place; and
°° Recoverable amount at the date of the subsequent decision not to sell or distribute.
• A discontinued operation is a component of an entity that has been disposed of or is classified
as held for sale and:
°° Represents a separate major line of business or geographical area of operations;
°° Is part of a single co-ordinated plan to dispose of a separate major line of business or
geographical area of operations; or
°° 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, operationally and for financial reporting purposes, from the rest of the entity.
• An entity makes additional disclosures in relation to discontinued operations in the financial
statements and the notes to the financial statements.
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MIND MAP
SCOPE CLASSIFICATION
Classification and presentation Carrying amount will be recovered
• Apply to all non-current assets (NCA) and principally through sale rather than
disposal groups use → classify as Held for Sale (HFS)
Measurement Immediate sale + Sale must be highly
• Does not apply to all NCAs probable
• Excludes NCAs such as financial assets • To be highly probable:
and assets measured at fair value under - Management committed to sale
topic-specific HKFRSs → measure using - Active programme to locate buyer and
those HKFRSs complete plan initiated
MEASUREMENT - Actively marketed at reasonable price
in relation to fair value
Held for Sale (HFS): lower of carrying - Sale expected to be completed < one year
amount and Fair Value less Costs to Sell - Unlikely a significant change to the plan
(FVLCTS) will be made
Held for Distribution (HFD): lower of Held for Distribution (HFD): Broadly apply
carrying amount and Fair Value less same principals as HFS
Costs to Distribute (FVLCTD) • Extension of sale > one year:
Cease depreciation - Does not preclude classification as
Impairment: Write down NCA to HFS/HFD if the delay is caused by events
FVLCTS/FVLCD or circumstances beyond entity's control
NON-CURRENT ASSETS
Increase in FVLCS/FVLCD = Gain, limited HELD FOR SALE AND PRESENTATION AND DISCLOSURE
to not in excess of cumulative impairment DISCONTINUED Present information about discontinued
Disposal group OPERATIONS (HKFRS 5) operations
• Steps: • Discontinued operation: A component of an
- Remeasure HFS/HFD assets not within entity that is either disposed of classified
measurement scope of HKFRS 5 as HFS/HFD and:
- Add remeasured HFS/HFD assets to assets - Represents separate major line of
within measurement scope of HKFRS 5 business/geographical area of operations
- Determine FVLCS of disposal group and - Part of plan to dispose of separate major
compare it to the carrying amount of line of business/geographical area of
assets derived in Step 2 operation
• Allocate impairment: - Is a subsidiary acquired exclusively with
- First, to goodwill a view to resale
- Then, on pro-rata basis, to other NCAs • Component of an entity comprises
in disposal group operations and cash flows that can be
Reclassification → results in remeasurement clearly distinguished, operationally and for
financial reporting purposes, from the rest
Ceasing HFS/HFD classification: Measure
of the entity
at lower of
• Disclose income, tax and cash flows from
• Carrying amount before the initial
discontinued operations
classification, adjusted for
depreciation/revaluations Present information about other NCA
• Recoverable amount at the date of HFS/HFD
decision not to sell or distribute • Disclose HFS/HFD assets and disposal
group assets and liabilities separately
form other assets and liabilities
Answers to Knowledge Check Questions
Question 1
Answer A is correct. The measurement requirements apply to property, plant and
equipment.
Answer B is incorrect. From their scope, the measurement requirements of HKFRS 5
explicitly exclude deferred tax assets, which are subject to measurement requirements
in HKAS 12.
Answer C is incorrect. From their scope, the measurement requirements of HKFRS 5
explicitly exclude assets arising from employee benefits, which are subject to
measurement requirements in HKAS 19.
Answer D is incorrect. From their scope, the measurement requirements of HKFRS 5
explicitly exclude financial assets within the scope of HKFRS 9.
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N on- current A ssets H eld for Sale and D iscontinued O perations
Question 2
Answer A is incorrect. Though the sale must be expected to occur within 12 months, this
part of the criterion for the sale is highly probable.
Answer B is correct. HKFRS 5 requires that for a non-current asset to be classified as held
for sale, the asset must ‘be available for immediate sale in its present condition subject
only to terms that are usual and customary for sales of such assets and the sale must be
highly probable’.
Answer C is incorrect. The sale must be highly probably and not significantly likely.
Answer D is incorrect. The asset must be available for sale in its present condition and the
sale must be highly probable (being expected to occur within 12 months is a requirement
for the sale to be highly probable).
Question 3
Diggers & Ploughs should continue to classify the machine as held for sale. Though the
time to complete the sale extends beyond one year, the delay in the sale was caused by
events outside of the company’s control (government-imposed requirements). As Diggers
& Ploughs was not aware of the government requirements as of the date of initial
classification and the company has responded to the requirements, the company must
HKFRS
continue to classify the machine as held for sale in its 31 December 20X6 financial
5 para B1(b) statements.
Question 4
Tanker’s manufacturing facility would not meet the criteria to be classified for immediate
sale because Tanker’s intention is to sell the facility only after it ceases operations and
completes all existing customer orders, a delay in timing that Tanker imposed. The facility
would only meet the available for sale criteria when Tanker’s operations cease even if a
third party had agreed to purchase the facility before operations cease.
Question 5
Applying the steps noted in Section 15.2.2, the impairment loss will be determined by:
• Remeasuring the investment property within the disposal group in accordance
with HKAS 40 because it is outside the measurement scope of HKFRS 5. This
results in recording a fair value loss of HK$700,000 on the investment property
(HK$3.5 million − HK$2.8 million);
• Adding the remeasured investment property from Step 1 to the carrying amounts
of the disposal group assets within the measurement scope of HKFRS 5. This
results in a pre-written-down amount HK$11 million; and
• Compare the fair value less costs to sell of the held for sale disposal group
(HK$7.8 million) with the total carrying amount of the held for sale disposal group
assets (HK$11 million) as determined in Step 2. This results in an impairment of
HK$3.2 million as the carrying amount exceeds the fair value less costs to sell by
that amount.
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FINANCIAL REPORTING
The write-down can only be allocated to assets within the measurement scope of
HKFRS 5. Accordingly, the write-down will not be allocated to:
• Cash and trade receivables, as financial assets within the scope of HKFRS 9 are
excluded from the measurement scope of HKFRS 5; or
• The investment property measured at fair value.
The write-down is allocated to the goodwill and then on a pro-rata basis to the other
disposal group non-current assets within the measurement scope of HKFRS 5.
The write-down is allocated to the assets within the disposal group as follows:
Asset Pre-write-down Write-down Post-write-down
HK$ HK$ HK$
Goodwill 1,700,000 (1,700,000) –
Investment property (fair value) 2,800,000 – 2,800,000
Property, plant and equipment 5,200,000 (1,500,000)a
3,700,000
Cash 400,000 – 400,000
Trade receivables 900,000 – 900,000
11,000,000 (3,200,000) 7,800,000
a
1,500,000 = 3,200,000 − 1,700,000
Question 6
The impairment reversal loss will be determined by:
• Remeasuring the investment property within the disposal group in accordance
with HKAS 40 because it is outside the measurement scope of HKFRS 5. This
results in recording a revaluation gain of HK$900,000 on the investment property
(HK$3.7 million − HK$2.8 million);
• Adding the remeasured investment property from Step 1 to the carrying amounts
of the disposal group assets that are within the measurement scope of HKFRS 5.
This results in a pre-reversal amount HK$8.7 million; and
• Compare the fair value less costs to sell of the held for sale disposal group
(HK$9.4 million) with the total carrying amount of the held for sale disposal
group assets (HK$8.7 million) as determined in Step 2. This results in a reversal
of HK$700,000 as the fair value less costs to sell exceeds the carrying amount by
that amount.
The reversal can only be allocated to assets within the measurement scope of HKFRS 5.
Accordingly, the reversal will not be allocated to:
• Cash and trade receivables as financial assets within the scope of HKFRS 9 are
excluded from the measurement scope of HKFRS 5; or
• The investment property measured at fair value.
As the reversal of impairment of goodwill is not permitted, the reversal is allocated
only to property, plant and equipment.
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N on- current A ssets H eld for Sale and D iscontinued O perations
Asset Pre-reversal Reversal Post-reversal
HK$ HK$ HK$
Goodwill – – –
Investment property (fair value) 3,700,000 – 3,700,000
Property, plant and equipment 3,700,000 700,000 4,400,000
Cash 400,000 – 400,000
Trade receivables 900,000 – 900,000
8,700,000 700,000 9,400,000
Question 7
Answer A is incorrect. An asset is no longer depreciated when classified as held for sale.
Answer B is incorrect. The asset must be remeasured to the lower of: (1) the carrying
amount had the asset never been classified as held for sale; and (2) the recoverable
amount at the date of the subsequent decision not to sell.
Answer C is correct. When an asset no longer meets the criteria to be classified as held
for sale, its carrying amount is remeasured to the lower of: (1) the carrying amount had
the asset never been classified as held for sale; and (2) its recoverable amount at the date
of the subsequent decision not to sell. Had it never been classified as held for sale, the
carrying amount of the asset is equal to HK$550,000 ([750,000/15 years] * 4 years), which is
lower than the recoverable amount (HK$575,000).
Answer D is incorrect. Had the asset never been classified as held for sale (HK$550,000),
the carrying amount is lower than the recoverable amount (HK$575,000).
Question 8
Answer A is incorrect. A subsidiary acquired exclusively with a view to resale is a type of
discontinued operation.
Answer B is correct. It is not a requirement that a discontinued operation be accounted for
using the equity method.
Answer C is incorrect. A discontinued operation may be a part of a single co-ordinated plan
to dispose of a separate major line of business or geographical area of operations.
Answer D is incorrect. A discontinued operation may represent a separate major line of
business or geographical area of operations.
Question 9
Answer A is incorrect. Disclosure of a single amount comprising the post-tax profit or loss
of discontinued operations is required.
Answer B is correct. Disclosure of net cash flows is not required.
Answer C is incorrect. Disclosure of a single amount comprising the post-tax gain or loss
recognised on the measurement to fair value less costs to sell or on the disposal of the
assets or disposal group(s) constituting the discontinued operation is required.
Answer D is incorrect. Disclosure of the amount of income from continuing operations and
from discontinued operations attributable to owners of the parent is required.
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FINANCIAL REPORTING
Question 10
All Sorts has made the following two errors in its presentation:
1. The disposal group assets and liabilities have been offset, which is not permitted
(3,400,000 − 1,300,000 = 2,100,000); and
2. The line of business was first classified as held for sale in the 20X7; however, the
comparative period was also re-presented, which is not permitted.
The two errors are indicated in the extract of the statement of financial position
presented below.
All Sorts Manufacturing
Statement of Financial Position (extract)
(As of 31 December 20X7)
20X7 20X6
HK$ HK$
Non-current assets
Property, plant and equipment 31,400,000 34,400,000
Intangibles 28,200,000 24,200,000
Deferred tax assets 9,200,000 7,600,000
68,800,000 66,200,000
Net non-current assets classified as held for sale 2,100,000 2,100,000
Total assets 98,500,000 102,400,000
The statement of financial position should be presented as follows:
All Sorts Manufacturing
Statement of Financial Position
(As of 31 December 20X7)
20X7 20X6
HK$ HK$
Current assets
Cash 5,600,000 10,200,000
Receivables 9,400,000 7,400,000
Prepayments 2,300,000 1,800,000
Contract assets 1,800,000 1,500,000
Inventories 8,500,000 13,200,000
27,600,000 34,100,000
868
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N on- current A ssets H eld for Sale and D iscontinued O perations
All Sorts Manufacturing
Statement of Financial Position
(As of 31 December 20X7)
20X7 20X6
HK$ HK$
Non-current assets
Property, plant and equipment 31,400,000 34,400,000
Intangibles 28,200,000 24,200,000
Deferred tax assets 9,200,000 7,600,000
Farm equipment business assets – 3,400,000
68,800,000 69,600,000
Non-current assets classified as held for sale 3,400,000 –
Total assets 99,800,000 103,700,000
Current liabilities
Payables 8,200,000 6,900,000
Contract liabilities 1,300,000 1,100,000
Farm equipment business liabilities – 1,300,000
9,500,000 9,300,000
Non-current liabilities
Loans 28,400,000 29,000,000
Lease liabilities 14,200,000 13,500,000
42,600,000 42,500,000
Liabilities classified as held for sale 1,300,000 –
Total liabilities 53,400,000 51,800,000
Net assets 46,400,000 51,900,000
869
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FINANCIAL REPORTING
EXAM PRACTICE
QUESTION 1
Minenculture is a private company headquartered in Hong Kong. The company operates in
three principal markets: minerals, energy and agriculture.
Minenculture has determined that each line of business is a separate cash-generating
unit (CGU).
The company’s minerals CGU is primarily engaged in the mining of copper throughout
Australia and South America. The copper is used in wiring and the production of solar
cells. As of 30 June 20X5, Minenculture had classified a parcel of land located alongside a
copper mine as held for sale. At the time, the fair value of the land was HK$1.75 million,
and estimated costs to complete the sale were HK$50,000. Minenculture was subsequently
unable to identify a buyer for the land, and on 17 November 20X5, decided to distribute
the land to owners of the company. As of 31 December 20X5, the fair value of the land was
HK$1.72 million, and estimated costs to distribute totalled HK$30,000.
The agriculture CGU purchases produce directly from growers. The produce is then
processed in facilities prior to selling to large supermarket retailers. Minenculture had
committed to a plan to sell the agriculture business during October 20X4, and the business
presented the disposal group as held for sale in its 31 December 20X4 financial statements.
The analysis of the fair value less costs to sell and allocation of the impairment to the assets
as of 31 December 20X4 in accordance with HKFRS 5 is detailed below:
Asset Pre-write-down Write-down Post-write-down
HK$ HK$ HK$
Goodwill 21,300,000 (21,300,000) –
Intangibles 13,400,000 (2,000,000) 11,400,000
Property, plant and equipment 53,600,000 (8,000,000) 45,600,000
Cash 9,400,000 – 9,400,000
Trade receivables 5,400,000 – 5,400,000
Marketable securities a
3,200,000 – 3,200,000
106,300,000 (31,300,000) 75,000,000
a
M
arketable securities are financial assets measured at fair value through profit or loss in accordance with HKFRS 9
Financial Instruments.
The agriculture business has yet to be sold. Though the company received a firm
commitment to purchase the business during August 20X5, the government requires an
application and approval for the sale of agricultural assets in mainland China. Minenculture
was aware of the government requirements but could not begin the application until a
buyer was committed to the purchase. Minenculture and the buyer have since completed
and submitted the application and are waiting on government approval for the sale. As of
31 December 20X5, the fair value less costs to sell of the agriculture business was $95,000,000.
It is now 9 January 20X6, and Minenculture’s financial accounting team are drafting the
31 December 20X5 financial statements. Identify and analyse any accounting issues with
respect to HKFRS 5. Provide calculations where appropriate.
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N on- current A ssets H eld for Sale and D iscontinued O perations
QUESTION 2
Minenculture’s third CGU, the energy CGU, is involved in coal mining throughout Australia
and Canada. Coking coal is sold to local steel producers, and brown coal is sold to emerging
countries to be used in base load power generation.
Essential to Minenculture’s mining operations is a fleet of coal excavators. Due to falling
prices of the export of coal, Minenculture intends to sell one its aging excavators.
(a) Under the following scenarios, determine whether the coal excavator would be
available for immediate sale as of 31 December 20X5:
i. Minenculture intends to transfer the excavator only after the buyer completes and
lodges the required documentation to transfer ownership of the machine with the
local government.
ii. Due to the suspension of mining operations at Minenculture’s mines, the company
is using the excavator to mine a specified tonnage of coal for a customer at a
nearby coal mine in exchange for a fixed fee.
Minenculture has exhausted the coal resources in a mine located adjacent a town
approximately 200 kilometres west of Sydney, Australia. Minenculture was committed to the
sale of the part of the land on the outer boundary of the mine and classified the land as held
for sale as of 31 December 20X5.
(b) Under the following scenarios, determine whether the land would continue to be
classified as held for sale:
i. During June 20X6, a residential land developer made a firm purchase commitment
for the land. Following the purchase commitment, the buyer’s inspection of the
land identifies significant soil damage not previously known to exist. In accordance
with the terms of the contract of sale, Minenculture is required by the buyer to
make good the damage, which will extend the period required to complete the sale
beyond one year. Minenculture has initiated actions to rectify the soil damage, and
satisfactory rectification of the damage is highly probable.
ii. During the year ended 31 December 20X6, the market for land within the area
significantly declined. Management of Minenculture was of the view that the market
deterioration was temporary and, therefore, did not change the price to which the
land was actively marketed.
ANSWERS TO EXAM PRACTICE
QUESTION 1
This suggested answer has been set out by CGU of Minenculture.
Minerals CGU
The parcel of land must be reclassified from being held for sale to being held for distribution
to owners. In accordance with HKFRS 5, Minenculture will measure the land at fair value
less costs to distribute and recognise the reduction in the fair value less costs to distribute
applying the impairment loss requirements. Minenculture will recognise an impairment
loss of HK$10,000, being the difference between the fair value less costs to sell as of
30 June 20X5 (HK$1.7 million) and fair value less costs to distribute as of 31 December 20X5
(HK$1.69 million).
871
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FINANCIAL REPORTING
Agriculture CGU
Based on the facts presented, Minenculture must continue to classify the disposal group as
held for sale as of 31 December 20X5. Though the period to complete the sale has extended
beyond one year, the delay was caused by events outside of Minenculture’s control.
Minenculture was aware the government requirements would cause the sale process to
HKFRS
extend beyond 12 months (HKAS 5.B1(a)). Minenculture submitted an application for the
5.B1(a)(ii) transfer of assets (HKFRS 5.B1(a)(i)) and has received a firm purchase commitment.
As of 31 December 20X5, the fair value less costs to sell is HK$95 million, an increase of
HKAS
HK$20 million. The reversal is applied only to the assets within the measurement scope of
36.124 HKFRS 5. No reversal is applied to goodwill. The reversal of the impairment loss allocated to
HKFRS
each non-current asset cannot exceed the cumulative impairment loss on that specific
5.22(b) non-current asset. Accordingly, Minenculture will recognise impairment reversals in relation
to intangibles and property, plant and equipment, totalling HK$2 million and HK$8 million,
respectively. The other HK$10m of the total of HK$20 million increase is the fair value less
costs to sell is ignored. As of 31 December 20X5, the carrying amounts of the assets within
the disposal group are listed below.
Asset Pre-write- Write- Post-write- Reversal 31 December
down down down (million) 20X5
(million) (million) (million) (million)
Goodwill 21.3 (21.3) – – –
Other intangibles 13.4 (2.0) 11.4 2.0 13.4
Property, plant 53.6 (8.0) 45.6 8.0 53.6
and equipment
Cash 9.4 – 9.4 – 9.4
Trade receivables 5.4 – 5.4 – 5.4
Marketable securities 3.2 – 3.2 – 3.2
106.3 (31.3) 75.0 10.0 85.0
QUESTION 2
(a) In accordance with paragraph 7 of HKFRS 5, under each scenario, Minenculture must
determine whether the excavator is available for immediate sale in its present condition
subject only to terms that are usual and customary for sales of such assets.
i. The excavator does meet the available for sale criterion as the conditions of the sale
are customary for sales of such assets; that is, the local government requires that
the excavator is registered under the new buyer’s name.
ii. Minenculture cannot transfer ownership of the excavator as it is currently
contracted out to a third party. The delay in timing of the transfer imposed by
Minenculture (as the seller) demonstrates the excavator is not unavailable for
immediate sale. The criterion in paragraph 7 of HKFRS 5 would not be met until
Minenculture had fulfilled its obligation to extract the specified tonnage of coal
promised to the third party.
872
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N on- current A ssets H eld for Sale and D iscontinued O perations
(b) In accordance with paragraph B1 of HKFRS 5, under each scenario, Minenculture
must determine whether the land must continue to be classified as held for sale as of
31 December 20X6.
i. In accordance with paragraph B1(b) of HKFRS 5, the land should continue to be
classified as held for sale as of 30 June 20X6 because Minenculture has obtained a
firm purchase commitment from the land developer, and as a result by way of the
inspection, the buyer has unexpectedly identified soil damage and exercised its
right under the contract to require Minenculture to make good the damage.
HKFRS
5 para Minenculture began remediating the soil damage (HKFRS 5 para B1(b)(i)), and the
B1(b)(ii) company reasonably expects to achieve satisfactory rectification.
ii. In accordance with paragraph B1(c) of HKFRS 5, the land should not continue to be
classified as held for sale as of 31 December 20X6. Though Minenculture may not
reasonably have expected the price of land in the area to significantly deteriorate,
the company has not taken any necessary actions to respond to the change in
circumstances (failing HKFRS 5 para B1(c)(i)) and Minenculture has not reduced the
price at which the land is actively marketed (failing HKFRS 5 para B1(c)(ii)).
873
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M11_c15.indd 874 10/26/2022 1:48:56 PM
16
Accounting Policies,
Changes in Accounting
Estimates and Errors
CHAPTER TOPIC LIST
16.1 Overview 16.3 Accounting Estimates
16.1.1 Scope 16.3.1 Accounting for Changes in
16.1.2 Terminology Accounting Estimates
16.2 Accounting Policies 16.3.2 Disclosure
16.2.1 Selection and Application of 16.4 Errors
Accounting Policies 16.4.1 Accounting for Prior Period
16.2.2 Consistency of Accounting Errors
Policies 16.4.2 Limitations on Retrospective
16.2.3 Changes in Accounting Restatement
Policies 16.4.3 Disclosure
16.2.4 Disclosure
875
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FINANCIAL REPORTING
LEARNING OUTCOMES
PRINCIPAL LO3: EVALUATE AND ADVISE ON APPROPRIATE ACCOUNTING PRINCIPLES TO ACCOUNT
FOR COMPLEX BUSINESS TRANSACTIONS
LO3.01: A
ccount for, evaluate and advise on business transactions in accordance with Hong
Kong Financial Reporting Standards as they relate to: Accounting policies, changes in
accounting estimates and errors
3.01.01 Contrast and classify accounting policies and accounting estimates
3.01.02 Evaluate the financial impacts on a change in accounting policy, accounting estimate
and a prior period error
3.01.03 Prepare and appraise disclosure in respect of changes in accounting policies, changes in
accounting estimates and errors
876
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Acco u n ti n g P o l ic ies , C ha ng es in A c c o u nt ing E s t im a t es a nd Er r or s
OPENING CASE
ALL ABOUT FURNITURE
A ll About Furniture Limited (All About Furniture) is a retail company offering a range of
discount office and home furniture including sofas, beds, lounge chairs, dining tables and
chairs, outdoor furniture, and office desks and chairs. It has five retail stores located in Hong
Kong, and sources its products from several manufacturers from mainland China. All About
Furniture is the largest customer of each manufacturer. Each manufacturer manufactures
the furniture according to the design, type and quantity requested by All About Furniture and
delivers the furniture on a quarterly basis to coincide with All About Furniture’s seasonal range.
Since its commencement, All About Furniture has accounted for its inventories on hand at
the end of each reporting period using the first-in, first-out (FIFO) method.
For each furniture sale, All About Furniture offers its customers a written warranty against
defects. Under this warranty, All About Furniture agrees to replace the defective furniture or
offer a full refund if returned within three months from the time of sale.
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FINANCIAL REPORTING
OVERVIEW
An entity’s financial statements cannot be prepared without first selecting and then applying
accounting policies to the transactions it entered or other events or conditions it experienced
during the reporting period. Accounting policies are the principles, rules and practices an entity
follows in preparing and presenting its financial statements. Some accounting policies are
prescribed by accounting standards. Others can, in the absence of an accounting standard,
be developed by management based on their judgement and experience but must provide
relevant and reliable information for financial statement users.
Within an entity’s financial statements, not all items can be measured with precision.
Measurement uncertainty arises because of inherent uncertainties in the entity’s activities,
including the inability to predict future events beyond the entity’s control with exactness. In
the presence of uncertainty, the entity makes an ‘accounting estimate’ to measure the financial
statement item, drawing upon judgement and experience and using up-to-date and reliable
information.
An entity may change an accounting policy relating to a transaction, other event or
condition, or change an accounting estimate when measuring a financial statement item. In
addition, when preparing an entity’s financial statements, errors may be detected that arose
in prior periods for various reasons, including mathematical mistakes, mistakes in applying
accounting policies, oversights or misinterpretations of facts or fraud. Once detected, these
errors must be corrected to help ensure the financial statements are reliable.
This chapter outlines the criteria to guide management in selecting and applying accounting
policies, as well as how to account for a change in accounting policy, a change in an accounting
estimate and a correction of a prior period error. Initially, you will gain an understanding of
the accounting references management should rely upon when developing an accounting
policy. Subsequently, you will learn how to contrast and classify accounting policies and
accounting estimates, which will to assist in your understanding of how to account for changes
in accounting policies and accounting estimates, and prior period errors. As part of this, you
will also be able to evaluate the financial impacts of a change in accounting policy, accounting
estimate and a prior period error. To do this, you must understand whether a change in
accounting policy, a change in accounting estimate, or a correction of a prior period error is to
be applied prospectively or retrospectively and how to adjust the accounting treatment when
an entity is faced with limitations on retrospective application. Finally, you will be able to
prepare and appraise note disclosures pertaining to a change in accounting policy, a change in
accounting estimate and a prior period error.
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Acco u n ti n g P o l ic ies , C ha ng es in A c c o u nt ing E s t im a t es a nd Er r or s
1 6 . 1 OVERVIEW
This chapter distinguishes between, and discusses how an entity is to account for, a change in
accounting policy, a change in an accounting estimate, and a correction of an error. Such issues
are governed by HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors (HKAS 8).
The objective of HKAS 8 is to prescribe:
• The criteria for selecting and changing accounting policies; and
• The accounting treatment and disclosure of changes in accounting policies, changes in
HKAS 8.1 accounting estimates and corrections of error.
HKAS 8 aims to enhance the relevance and reliability of an entity’s financial statements and
to enhance the comparability of those financial statements over time and with the financial
HKAS 8.1 statements of other entities.
In this section, you will gain an understanding of the scope of HKAS 8 and be introduced to
terminology that build your understanding of the difference a change in accounting policy, a
change in an accounting estimate and a correction of a prior period error.
16.1.1 Scope
HKAS 8 is to be applied by entities in selecting and applying accounting policies and accounting
for changes in accounting policies, changes in accounting estimates and corrections of prior
HKAS 8.3 period errors.
Entities are to account for and disclose the tax effects arising from corrections of prior
period errors or retrospective adjustments made to apply changes in accounting policies in
HKAS 8.4 accordance with HKAS 12 Income Taxes.
16.1.2 Terminology
HKAS 8 defines ‘accounting policies’ as the specific principles, bases, conventions, rules and
HKAS 8.5 practices applied by an entity in preparing and presenting financial statements.
Accounting estimates are monetary amounts in financial statements that are subject to
HKAS 8.5 measurement uncertainty.
A prior period error is an omission from and misstatement in an entity’s financial
statements for one or more prior periods due to a failure to use or the misuse of reliable
information that:
• Was available when financial statements for those prior periods were authorised for
issue; and
• Could reasonably be expected to have been obtained and taken into account in the
HKAS 8.5 preparation and presentation of those financial statements.
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1 6 . 2 ACCOUNTING POLICIES
This section outlines the HKAS 8 requirements on how to develop and apply an accounting
policy, as well how to account for a change in accounting policy, including the type of
information to be disclosed.
16.2.1 Selection and Application of Accounting Policies
In accounting for a transaction entered into or an event or condition experienced, an entity’s
management must initially select a policy to apply and then apply it to the transaction,
event, or condition. An HKFRS may stipulate a specific accounting policy is to be applied to
the transaction, event or condition (e.g. a cash-generating unit for which goodwill has been
allocated is to be tested annually for impairment, per HKAS 36 Impairment of Assets, see
Chapter 14). The HKFRS may give management the choice between alternate accounting
policies (e.g. entities can choose between the first-in, first-out (FIFO) or weighted average cost
(WAC) formulae in valuing inventory, per HKAS 2 Inventories, see Chapter 6). Alternatively, no
HKFRS-prescribed accounting policy may exist to follow (e.g. the basis on which an entity’s
warranty provision is to be determined).
An entity applies the requirements of HKAS 8 in the selection and application of accounting
policies to a transaction, other event or condition only if no other HKFRS specifically applies to
the transaction, event or condition. When an HKFRS specifically applies to a transaction, other
event or condition, the accounting policy or policies applied to that item are to be determined
HKAS 8.7 by applying the HKFRS and not HKAS 8.
For the purposes of HKAS 8, HKFRSs comprise HKFRSs, Hong Kong Accounting Standards
HKAS 8.5 (HKASs) and Interpretations.
HKAS 8 (April 2021) requires that in the absence of a HKFRS that specifically applies to a
transaction, other event or condition, management shall use its judgement 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
an entity;
(ii) reflect the economic substance of transactions, other events and conditions, and
are not merely the legal form;
(iii) are neutral, i.e., free from bias;
(iv) are prudent; and
HKAS
8.10 (v) are complete in all material respects.
HKAS Exhibit 16.1 outlines the source documents management must refer to in assisting to make
8.11–12 this judgement.
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Management shall refer to: Management may also consider:
First, the requirements in HKFRSs The most recent pronouncements of
dealing with similar and related issues other standard-setting bodies that
use a similar conceptual framework
to develop accounting standards,
Second, the definitions, recognition other accounting literature such as
criteria and measurement concepts Accounting Guidelines and Accounting
for assets, liabilities, income and Bulletins, and accepted industry
expenses in the Conceptual Framework practice provided these are not in
for Financial Reporting (the Framework) conflict with the HKFRSs and the
if HKFRSs offer no assistance Framework already referred to by
(HKAS 8.11) management (HKAS 8.12)
EXHIBIT 16.1 Alternative sources of information for management
to refer to in making an HKAS 8.10 judgement
Illustrative Example 1
The following information relates to the measurement of All About Furniture’s warranty
provision for the 20X2 reporting period:
• All About Furniture determines it will calculate its warranty provision based on the
proportion of last period’s products sold that were returned under warranty; and
• For 20X1, the warranty claims amounted to 2% of sales, resulting in the 20X2
warranty provision being calculated as 2% of current period sales.
The accounting policy All About Furniture’s has selected in relation to its warranty
provision can be stated as follows:
Our warranty provision will be calculated based on last period’s products sold that were
returned under warranty.
This statement constitutes an accounting policy under HKAS 8 because it represents
a rule or practice that All About Furniture is going to apply in preparing and presenting its
financial statements.
Measuring the warranty provision at 2% of current period sales is an accounting
estimate under HKAS 8 because judgement has been exercised in estimating the amount
of product returned under warranty during the current period.
16.2.2 Consistency of Accounting Policies
Having selected an accounting policy, whether that be as prescribed by an HKFRS or developed
by management, an entity is expected to apply that accounting policy consistently. An entity is
required to select and apply its accounting policies consistently for similar transactions, other
events and conditions unless an HKFRS specifically requires or permits categorisation of items for
HKAS which different policies may be appropriate. If an HKFRS requires or permits such categorisation,
8.13 an appropriate accounting policy must be accepted and applied consistently to each category.
The reason for requiring an entity to consistently select and apply accounting policies is
to enhance the comparability of the entity’s financial statements over time. An entity is not,
however, required to apply an accounting policy indefinitely, as the following section outlines.
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16.2.3 Changes in Accounting Policies
Accounting policies are defined in HKAS 1 and HKAS 8 as the specific principles, bases,
conventions, rules and practices applied in preparing and presenting financial statements.
Application of accounting policies often involves estimation of amounts for inclusion in the
financial statements. This chapter deals with such estimates and changes therein, and with the
treatment of accounting errors.
An entity is permitted to change an accounting policy only if the change:
• Is required by a HKFRS; or
• Results in the financial statements providing reliable and more relevant information
HKAS about the effects of transactions, other events or conditions on the entity’s financial
8.14 position, financial performance or cash flows.
It is important to distinguish between the initial application of an accounting policy and a
change in accounting policy due to the different reporting requirements of each. To help clarify
the distinction, HKAS 8 states that the following are not changes in accounting policy:
• The application of an accounting policy for transactions, other events or conditions that
differ in substance from those previously occurring. For example, recall that an entity is
to apply its accounting policies consistently for similar transactions. If an entity adopts
an accounting policy for a transaction that differs (in accounting policy and transaction
type) to what occurred previously, this is not a change in accounting policy; and
• The application of a new accounting policy for transactions, other events or conditions
HKAS that did not occur previously or were immaterial. For example, the initial application of
8.16 an accounting policy for a first-time transaction.
An entity’s first-time adoption of a policy to revalue its assets in accordance with HKAS 16
Property, Plant and Equipment (HKAS 16) or HKAS 38 Intangible Assets (HKAS 38) is a change in
accounting policy. However, this accounting policy change is to be dealt with as a revaluation
HKAS under HKAS 16 or HKAS 38 (see Chapters 7 and 11). As such, HKAS 8 and the following
8.17, 18 discussion does not apply to these types of changes in accounting policy.
Once a change in accounting policy has been identified, determining how to account for
the accounting policy change is required. Accounting for a change in accounting policy varies
according to why the change was made (i.e. required by an HKFRS or a voluntary change to
provide relevant and more reliable information about the entity) and, if required by an HKFRS,
whether the HKFRS contains transitional provisions on the initial application of the HKFRS.
More specifically, when a change in accounting policy results from the initial application of
an HKFRS, the entity is required to:
• Account for the accounting policy change in accordance with the specific transitional
provisions, if any, in that HKFRS. Depending upon the specific transitional provisions,
the entity may be required to apply the change in accounting policy retrospectively or
prospectively; and
HKAS • Apply the accounting policy change retrospectively when the HKFRS does not include
8.19 specific transitional provisions applying to that change.
When a change in accounting policy is voluntarily undertaken by management to provide
HKAS reliable and more relevant information, the entity is required to apply the change
8.19 retrospectively.
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To apply a change in accounting policy retrospectively, an entity is to apply the new
HKAS
accounting policy to transactions, other events and conditions as if that policy had always been
8.5 in effect. In essence, this means the new accounting policy is to be applied from the earliest
date the transactions, events, or other conditions occurred. To achieve this outcome, an entity
must adjust the opening balance of each affected component of equity (e.g. retained earnings)
HKAS
for the earliest prior period presented and adjust the other comparative amounts disclosed for
8.22 each prior period presented.
Illustrative Example 2
A lease arrangement is when one entity (the lessee) promises to pay another entity (the
lessor) for the right to use the lessor’s asset for a specified period of time. HKFRS 16
Leases (HKFRS 16) is a recent accounting standard that significantly changes how a lessee
is to account for leasing arrangements in its financial statements. Under HKAS 17
Insurance Contracts, which preceded HKFRS 16, some leasing arrangements (termed
‘operating leases’) did not require the lessee to recognise its right to use the lessor’s
asset as an asset, nor the obligation to make lease payments to the lessor as a liability, in
its statement of financial position. Under HKFRS 16, a lessee must now recognise a
HKAS right-of-use asset and lease liability in its statement of financial position for all leases. In
8.14(a)
accordance with HKAS 8, this change in accounting for leases constitutes a change in
HKFRS
16.C8-C10 accounting policy required by a HKFRS. As HKFRS 16 contains transitional provisions
HKAS relating to leases previously classified as operating leases, a lessee is to account for the
8.19(a) accounting policy change in accordance with the HKFRS 16 transitional provisions.
The transitional provisions of HKFRS 16 state a lessee is to apply HKFRS 16 to its leases
retrospectively:
• To each prior reporting period presented, applying HKAS 8 (i.e. apply HKFRS 16 as if
has always been in effect); or
• With the cumulative effect of initially applying HKFRS 16 recognised as an
adjustment to the opening balance of retained earnings (or other component of
HKFRS equity, as appropriate) at the date of initial application. Under this option, the
16.C5; C7 lessee is not to restate comparative information.
Apply and Analyse 1
During the reporting period ended 31 December 20X4, All About Furniture changed its
cost formula to value its inventory. In previous periods, All About Furniture used the FIFO
cost formula. The management of All About Furniture has now decided to use the WAC
formula. Management judges that the WAC formula provides more relevant information
about the cost of inventories and cost of goods sold because it more accurately captures
inventory flow from acquisition from manufacturers to point of sale to customers. In
addition, the adoption of a WAC formula is consistent with industry practice, enhancing the
comparability of All About Furniture’s financial statements.
Inventory currently on hand dates back to purchases made in 20X3, 20X2, 20X1 and
20X0. Management provides the following end-of-year figures for inventories on hand
under both the FIFO and WAC formulas for each respective prior period:
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Apply and Analyse 1 (continued)
Formula 20X3 20X2 20X1 20X0
HK$’000 HK$’000 HK$’000 HK$’000
FIFO 3,785 2,960 3,640 4,250
WAC 3,035 2,140 2,730 3,130
Change in end-of-year figures (750) (820) (910) (1,120)
The following amounts are also available for 20X3 (as reported) and 20X4 (draft, after
implementing the change in cost formula):
20X4 20X3
HK$’000 HK$’000
Sales 17,300 21,800
Cost of goods sold (5,210) (8,280)
Profit before income taxes 12,090 13,520
Income taxes (1,995) (2,231)
Profit 10,095 11,289
Inventories on hand 4,351 3,785
The following additional information is also available:
• Retained earnings as of 1 January 20X3 is HK$6,125,000;
• The income tax rate is 16.5%;
• No dividends have been declared or paid; and
• The change in inventory cost formula also extends to the valuation of inventory for
tax purposes. As such, the change in cost formula has a corresponding effect on
All About Furniture’s accounting and taxable profits, and there are no deferred tax
consequences of this change.
Refer to Chapter 19: Income Taxes to gain an understanding of how to account for
deferred taxes.
Determine how All About Furniture will account for the change in inventory
cost formula.
Analysis
Applying HKAS 8, a change in accounting policy has occurred as All About Furniture has
altered its principle for measuring inventories on hand. Under HKAS 8, as the change
in inventory cost formula is voluntarily undertaken by management it is to be applied
retrospectively to the extent it is practicable to do so. Based on the facts provided,
management can determine the period-specific effects of the change in inventory cost
formula (20X3, 20X2, 20X1 and 20X0). As evident from the table above, the change in cost
formula will result in a decrease in reported inventories on hand in each prior period
(20X3: HK$750,000; 20X2: HK$820,000; 20X1: HK$910,000; and 20X0: HK$1.12 million).
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Apply and Analyse 1 (continued)
The decrease in reported inventories on hand in each period is to be matched by an
opposing increase in cost of goods sold, resulting in an increase in cost of goods sold of
HK$750,000 in 20X3 and HK$2.85 million (HK$820,000 + HK$910,000 + HK$1,120,000)
prior to 20X3.
In the financial statements of the current period (20X4), All About Furniture is required
to adjust the opening balance of retained earnings for periods prior to 20X3 and to adjust
the other comparative amounts disclosed for the 20X3 prior period.
An extract of the statement of profit or loss and other comprehensive income for the
20X4 reporting period would look as follows:
All About Furniture
Extract from the statement of profit or loss and other
comprehensive income
(restated)
20X4 20X3
HK$’000 HK$’000
Sales 17,300 21,800
Cost of goods sold (5,210) (9,030)
Profit before income taxes 12,090 12,770
Income taxes (1,995) (2,107)
Profit 10,095 10,663
An extract of the statement of financial position for the 20X4 reporting period would
look as follows:
All About Furniture
Extract from the statement of financial position
(restated)
20X4 20X3
HK$’000 HK$’000
Inventories on hand 4,351 3,035
The retrospective application of the change in inventory cost formula specific to the
20X3 reporting period can be summarised as follows:
20X3 20X3 Change
(as reported) (restated)
HK$’000 HK$’000 HK$’000
Sales 21,800 21,800 –
Cost of goods sold (8,280) (9,030) +750
Profit before income taxes 13,520 12,770 –750
Income taxes (2,231) (2,107) –124
Profit 11,289 10,663 –626
Inventories on hand 3,785 3,035 –750
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Apply and Analyse 1 (continued)
From the preceding information, cost of goods sold (inventories on hand) is increased
(decreased) by HK$750,000. Due to the increase in cost of goods sold, restated profit
before income taxes is HK$750,000 lower, which has two effects. First, income tax expense
is restated downward by HK$123,750 because fewer taxes are payable on lower profits.
Second, retained earnings as of 31 December 20X3 is lower due to a lower restated profit
figure for the 20X3 reporting period. For illustrative purposes, this amount ignores the pre-
20X3 effects of the change in inventory cost formula.
An extract of the statement of changes in equity for the 20X4 reporting period would
be as follows:
All About Furniture
Extract from the statement of changes in equity
Retained earnings
HK$’000
Balance as of 31 December 20X2 as previously reported 6,125
Change in accounting policy for the shift from FIFO to the WAC (2,380)
formula (net of incomes taxes of HK$470)
Balance as of 31 December 20X2 as restated 3,745
Profit for the year ended 31 December 20X3 as restated 10,663
Balance as of 31 December 20X3 14,408
Profit for the year ended 31 December 20X4 10,095
Balance as of 31 December 20X4 24,503
The retrospective application of the change in inventory cost formula pre-20X3 is
reflected in the restatement of the retained earnings balance as of 31 December 20X2. The
cumulative effect of the change in inventory cost formula pre-20X3 is an increase in cost
of goods sold for HK$2.85 million with a corresponding reduction (before taxes) in profits
of pre-20X3 prior periods. After taxes, the reduction in profits of pre-20X3 prior periods is
HK$2,379,750 (HK$2.8 million – HK$470,250, with this amount rounded to HK$2,380 in the
preceding tables), requiring a restatement of retained earnings as of 31 December 20X2
by the same amount. The 20X3-specific effect of the change in inventory cost formula on
retained earnings is captured by the inclusion of the restated 20X3 profit figure.
HKAS 8, however, requires retrospective application only to the extent it is practicable
to do. As such, the entity is to apply the new accounting policy to prior periods (in which
the transaction, event or condition occurred) as far back as is practicable. The retrospective
application of a new accounting policy for a prior period becomes impracticable if:
• After making every reasonable effort to do so, the entity cannot determine the
period-specific effects or the cumulative effect of the accounting policy change;
• It requires assumptions about what management’s intent would have been in that prior
period; or
• It requires significant estimates of amounts and it is impossible to distinguish
objectively information about those estimates that:
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°° provides evidence of circumstances that existed on the date(s) as at which those
amounts are to be recognised, measured or disclosed; and
HKAS °° would have been available when the financial statements for that prior period were
8.5, 23 authorised for issue from other information.
As indicated in the preceding first bullet point, the effects of the retrospective application
of an accounting policy change may not be determinable for one or more specific prior
periods presented (i.e. period-specific effects) or cumulatively to all prior periods (i.e. the
cumulative effect).
The flowchart in Exhibit 16.2. can assist entities in applying HKAS 8 in accounting for a
change in accounting policy:
Is it impracticable to determine either the period-specific retrospective effects for one or
more prior periods presented, or at the beginning of the current period the cumulative
retrospective effect for all prior periods, of a change in accounting policy, where that
change is upon either the initial application of a HKFRS without transition provisions
or is voluntarily undertaken?
Yes
No
The entity is to adjust: Period-specific effects Cumulative effect
• The opening balance The entity is to adjust: The entity is to adjust the
of each affected • The carrying amount comparative information
component of equity of assets and/or to prospectively apply
for the earliest prior liabilities as at the the new accounting
period presented; and beginning of the policy from the start date
• The other comparative earliest prior period of the earliest period
amounts disclosed for presented for which (whether past or current)
each prior period period-specific effects practicable
presented as if the can be determined
new accounting policy (which could be the
had always been current period); and
applied. • The opening balance
of each affected
component of equity
for the period.
EXHIBIT 16.2 Flowchart to determine how to account for a change in accounting
policy under HKAS 8.24–8.27
16.2.4 Disclosure
In accordance with HKAS 8, an entity is required to disclose information about a change in
accounting policy (irrespective of whether it was voluntary or due to the initial application of a
HKFRS) when the change has:
• An effect on the current or any prior period;
• Would have such an effect except that it is impracticable to determine the amount of
the adjustment; or
HKAS
8.28, 29 • Might have an effect on future periods.
The disclosures are to be provided by an entity in the period in which the change in
HKAS accounting policy occurs (i.e. the current period). Financial statements of subsequent periods
8.28, 29 need not repeat the disclosures.
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The type of information to be disclosed depends on what caused the change. When a
change in accounting policy is due to the initial application of an HKFRS, an entity must disclose:
• The title of the HKFRS;
• That the change in accounting policy is made in accordance with its transitional
provisions (if the HKFRS contains transitional provisions);
• The nature of the change in accounting policy;
• A description of the transitional provisions (if applicable);
• The transitional provisions that might have an effect on future periods (if applicable);
• For the current period and each prior period presented to the extent practicable, the
amount of the adjustment:
°° For each financial statement line item affected; and
°° If HKAS 33 Earnings per Share applies to the entity, for basic and diluted Earnings per
Share (EPS);
• The amount of the adjustment relating to periods before those presented, to the extent
practicable; and
• If retrospective application is impracticable for a particular prior period, or for periods
before those presented, the circumstances that led to the existence of that condition
HKAS
and a description of how and from when the change in accounting policy has
8.28 been applied.
Apply and Analyse 2
HKT Limited and HKT Trust (collectively, HKT) is a pair of Hong Kong-listed corporations
that as a consolidated group represents one of the largest telecommunications providers
in Hong Kong. The following is an extract of the note disclosures provided by HKT in its
announcement of results for the year ended 31 December 2018. The note disclosures
specifically relate to changes in accounting policies due to the initial application of HKFRSs:
EXTRACT 1
2. Changes in Accounting Policies upon Adoption of New HKFRSs
This note explains the impact of the adoption of HKFRS 9 (2014) Financial Instruments and
HKFRS 15 Revenue from Contracts with Customers, and the early adoption of HKFRS 16 Leases
on the Groups’ financial statements.
Impacts on the Financial Statements
As a result of the changes in the Groups’ accounting policies, prior year financial
statements had to be restated as follows:
In HK$ million (except for earning per Share Stapled Unit/share of the Company)
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Apply and Analyse 2 (continued)
Consolidated income statement As originally HKFRS 15 HKFRS 16 Restated
for the year ended December 31, presented (Note 2(i)) (Note 2(ii))
2017 (extract)
Revenue 33,258 (161) (30) 33,067
Cost of sales (14,161) (2,207) 396 (15,972)
General and administrative (11,786) 1,938 (289) (10,137)
expenses
Finance costs, net (1,076) – (72) (1,148)
Profit before income tax* 6,080 (430) 5 5,655
Income tax (971) 71 2 (898)
Profit for the year* 5,109 (359) 7 4,757
Profit attributable to:
Holders of Share Stapled Units/ 5,097 (359) 7 4,745
shares of the Company
Non-controlling interests 12 – – 12
Profit for the year 5,109 (359) 7 4,757
Earnings per Share stapled Unit/ 67.34 (4.74) 0.09 62.69
share of the Company Basic (cents)
Diluted (cents) 67.31 (4.74) 0.09 62.66
EXTRACT 2
2. Changes in Accounting Policies upon Adoption of New HKFRSs (Continued)
Impacts on the Financial Statements (Continued)
In HK$ million
Consolidated statement of As at December HKFRS 15 HKFRS 16 As at
financial position (extract) 31, 2016 (Note 2(i)) (Note 2(ii)) January 1,
As originally 2017
presented Restated
ASSETS AND LIABILITIES
Non-current assets
Right-of-use assets – – 2,555 2,555
Intangible assets 10,695 (2,543) – 8,152
Fulfillment costs – 1,378 – 1,378
Customer acquisition costs – 648 – 648
Contract assets – 349 – 349
Other non-current assets 610 – 8 618
Current assets
Prepayments, deposits and other 5,226 (2,344) (92) 2,790
current assets
Contract assets – 771 – 771
Current liabilities
Accruals and other payables (5,109) – 50 (4,969)
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Apply and Analyse 2 (continued)
Consolidated statement of As at December HKFRS 15 HKFRS 16 As at
financial position (extract) 31, 2016 (Note 2(i)) (Note 2(ii)) January 1,
As originally 2017
presented Restated
Advances from customers (2,126) 1,861 – (265)
Contract liabilities – (1,276) – (1,276)
Lease liabilities – – (1,414) (1,414)
Current income tax liabilities (1,008) 200 11 (797)
Non-current liabilities
Deferred income (1,021) 1,021 – –
Contract liabilities – (801) – (801)
Lease liabilities – – (1,200) (1,200)
Net assetsa 39,159 (736) (82) 38,341
CAPITAL AND RESERVES
Reserves 39,088 (736) (82) 38,270
Total equity a
39,159 (736) (82) 38,341
a
he tables show the adjustments recognised for each individual line item. Line items that were not affected
T
by the changes have not been included. As a result, the sub-totals and totals disclosed cannot be recalculated
from the numbers provided.
EXTRACT 3
2. Changes in Accounting Policies upon Adoption of New HKFRSs (Continued)
Impacts on the Financial Statements (Continued)
In HK$ million
Consolidated As at HKFRS HKFRS As at HKFRS As at
statement of December 31, 15 16 December 9 January
financial position 2017 (Note (Note 31, (2014) 1,
(extract) As originally 2(i)) 2(h)) 2017 (Note 2018
presented Restated 2(iii)) Restated
ASSETS AND
LIABILITIES
Non–current assets
Right–of–use assets – – 2,220 2,220 – 2,220
Intangible assets 10,895 (2,929) – 7,966 – 7,966
Fulfillment costs – 1,378 – 1,378 – 1,378
Customer acquisition – 611 – 611 – 611
costs
Contract assets – 350 – 350 – 350
Available–for–sale 77 – – 77 (77) –
financial assets
Financial assets at – – – – 77 77
FVOCI
Deferred income tax 466 – 2 468 – 468
assets
Other non–current 692 – 150 842 – 842
assets
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Apply and Analyse 2 (continued)
Consolidated As at HKFRS HKFRS As at HKFRS As at
statement of December 31, 15 16 December 9 January
financial position 2017 (Note (Note 31, (2014) 1,
(extract) As originally 2(i)) 2(h)) 2017 (Note 2018
presented Restated 2(iii)) Restated
Current assets
Prepayments, deposits 5,484 (2,665) (47) 2,772 – 2,772
and other current
assets
Contract assets – 737 – 737 – 737
Current liabilities
Accruals and other (5,183) – 54 (5,129) – (5,129)
payables
Advances from (2,326) 2,085 – (241) – (241)
customers
Contract liabilities – (1,288) – (1,288) – (1,288)
Lease liabilities – – (1,157) (1,157) – (1,157)
Current income tax (1,138) 271 11 (856) – (856)
liabilities
Non–current liabilities
Deferred income (1,307) 1,307 – – – –
Contract liabilities – (952) – (952) – (952)
Lease liabilities – – (1,307) (1,307) – (1,307)
Net assetsa 39,059 (1,095) (74) 37,890 37,890
CAPITAL AND
RESERVES
Reserves 39,011 (1,095) (74) 37,842 – 37,842
Total equity a
39,059 (1,095) (74) 37,890 – 37,890
Fair value through other comprehensive income (‘FVOCI’)
a
he tables show the adjustments recognised for each individual line item. Line items that were unaffected by
T
the changes have not been included. As a result, the sub-totals and disclosed cannot be recalculated from the
numbers provided.
EXTRACT 4
2. Changes in Accounting Policies upon Adoption of New HKFRSs (Continued)
Impacts on the financial statements (continued)
(i) HKFRS15 Revenue from Contracts with Customers
The Groups have adopted HKFRS 15 Revenue from Contracts with Customers from January
1, 2018, which resulted in changes in accounting policies and adjustments to the amounts
recognised in the consolidated financial statements. In accordance with the transition
provisions in HKFRS 15, the Groups have elected to apply the new standard retrospectively
and have restated comparatives for the prior years presented.
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Apply and Analyse 2 (continued)
The adoption of HKFRS 15 mainly affects the accounting treatment of the Groups’ sale
contracts with customers in which the Groups have multiple performance obligations to
customers, such as provision of telecommunications services, sale of handsets, equipment
and gifts offered in the contracts.
Before adoption of HKFRS 15, the Groups capitalised the subsidised costs of handsets
and gifts as customer acquisition costs under intangible assets, with no revenue being
allocated to them. These customer acquisition costs were amortised over the respective
minimum enforceable contractual periods on a straight-line basis. Residual value method
was used to determine the fair value of the delivered element by deducting the fair value
of the undelivered element from the total contract consideration.
After the adoption of HKFRS 15, the total transaction price receivable from customers
in multiple-element sale contracts is allocated among all identified performance
obligations of the Groups in proportion to their respective stand-alone selling price.
Accordingly, although the total revenue being recognised for a multiple-element
sale contract over the contract period is unchanged, the amount and timing of revenue
recognition for individual performance obligations would be different after the adoption
of HKFRS 15. The revenue being allocated to handsets, equipment and gifts is recognised
upon the delivery to customers, which is generally upfront upon entering into the sale
contracts. The revenue allocated to telecommunications and other services is recognised
when services are rendered, which is generally over the contract period.
Moreover, subsidised costs of handsets and gifts are no longer capitalised and
amortised, but are required to be recognised as cost of sales immediately when the
corresponding revenue is recognised.
Nevertheless, other direct costs incurred to acquire contractual relationships with
customers and other costs incurred in fulfilling the contracts with customers are required
to be capitalised as customer acquisition costs and fulfillment costs under HKFRS 15 in the
consolidated statement of financial position, respectively.
As a result of the preceding changes, certain items in the consolidated income
statement as highlighted in the preceding note 2 are restated, resulting in a decrease in
retained profits attributable to holders of Share Stapled Units/shares of the Company as at
December 31, 2016 and profit attributable to holders of Share Stapled Units/shares of the
Company for the year ended December 31, 2017 of HK$736 million and HK$359 million,
respectively. The Groups’ EBITDA as defined and disclosed in the segment information is
also restated and decreased by HK$2.368 million for the year ended December 31, 2017.
For the Groups’ consolidated statement of cash flows, certain items including cash
outflow for certain contract related costs previously capitalised before HKFRS 15 adoption
are required to be reclassified to operating activities from investing activities. Nevertheless,
the Groups’ total net cash flow and adjusted funds flow as defined in the Trust Deed are
unaffected.
Source: HK Trust and HK Limited, Annual Results Announcement for the year ended 31 December 2018. < https://pcrd.
com/public/uploads/keys/22022019_Announcement_Relating_to_HKT_Limited.pdf>
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Apply and Analyse 2 (continued)
In the context of HKFRS 15 Revenue from Contracts with Customers, appraise whether
the information provided by HKT satisfies the disclosure requirements of HKAS 8.
Analysis
Within each extract, the following information is provided by HKT in accordance
with HKAS 8:
EXTRACT 1
• The title of the HKFRS (HKFRS 15 Revenue from Contracts with Customers); and
• For each prior period presented (i.e. the 2017 reporting period), the amount of the
adjustment:
°° For each income statement line item affected; and
°° For basic and diluted earnings per share (EPS).
EXTRACT 2
• For each prior period presented (i.e. the 2017 reporting period) the amount of the
adjustment for each statement of financial position line item affected.
EXTRACT 3
• For each prior period presented (i.e. the 2017 reporting period), the amount of the
adjustment for each statement of financial position line item affected.
EXTRACT 4
• That the change in accounting policy is made in accordance with its transitional
provisions (see first paragraph);
• The nature of the change in accounting policy (see second paragraph and
onward); and
• A description of the transitional provisions (see first paragraph).
In sum, the information provided by HKT is in accordance with the disclosure
requirements of HKAS 8.
When an entity has not applied a new HKFRS that has been issued but is not yet effective,
an entity is required to disclose this fact and known or reasonably estimable information
HKAS
relevant to assessing the possible impact the application of the new HKFRS will have on the
8.30 entity’s financial statements in the period of initial application.
When a change in accounting policy is voluntary an entity must disclose:
• The nature of the change in accounting policy;
• The reasons why applying the new accounting policy provides reliable and more
relevant information;
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FINANCIAL REPORTING
• The amount of the adjustment for the current period and each prior period presented
to the extent practicable:
°° For each financial statement line item affected; and
°° If HKAS 33 Earnings per Share applies to the entity, for basic and diluted
earnings per share
• The amount of the adjustment relating to periods before those presented to the extent
practicable; and
• The circumstances that led to the existence of that condition and a description of how
and from when the change in accounting policy has been applied if retrospective
HKAS
application is impracticable for a particular prior period or for periods before those
8.29 presented.
Illustrative Example 3
Vodafone Group Plc (Vodafone) is a multinational telecommunications company with
headquarters in London, England. Vodafone’s financial statements are prepared in
accordance with International Financial Reporting Standards (IFRS), upon which HKFRSs
are based.
The following is Vodafone’s note disclosure in relation to a voluntary change in
accounting policy made during the reporting period ended 31 March 2009. As evident from
the extracts, Vodafone provides the information specified in the preceding bullet points,
where applicable, as indicated by the arrows provided.
39. Change in Accounting Policy
During the year, the Group changed its accounting policy with respect to the acquisition
of minority interests in subsidiaries. The Group now applies the economic entity method,
under which such transactions are accounted for as transactions between shareholders
and there is no remeasurement to fair value of net assets acquired that were previously
attributable to minority shareholders. Prior to this change in policy, the Group applied
the parent company method to such transactions and to assets attributable to minority
interests immediately prior to the respective acquisition, including goodwill and other
acquired intangible assets were remeasured to fair value at the date of acquisition.
The Group believes the new policy is preferable as it more closely aligns the accounting
for these transactions with the treatment of minority interest as a component of equity
and will aid comparability.
The impact of this voluntary change in accounting policy on the consolidated financial
statements is primarily to reduce goodwill and acquired intangible assets and related
income statement amounts arising on such transactions. This change did not result in
a material impact on the current year or any years included within these consolidated
financial statements. The impact on each line item of the primary financial statements
since the Group’s adoption of IFRS is shown in the following table:
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Illustrative Example 3 (continued)
As reported Adjustments Restated
2007 2006 2005 2007 2006 2005 2007 2006 2005
£m £m £m £m £m £m £m £m £m
Consolidated income
statement
(Loss)/profit for the
financial year from
discontinued (491) (4,588) 1,102 75 1,690 80 (416) (2,898) 1,182
operations
(Loss)/profit for the (5,297) (21,621) 6,518 75 1,690 80 (5,222) (20,131) 6,598
financial year
Attributable to equity (5,426) (21,916) 6,410 75 1,690 80 (5,351) (20,226) 6,490
shareholders
Basic (loss)/earnings
per share
(Loss)/profit from (0.90)p (7.35)p 1 56p 0.14p 2.70p 0.12p (0.76)p (4.65)p 1.68p
discontinued
operations
(Loss)/profit for the (9.84)p (35.01)p 9.68p 0.14p 2.70p 0.12p (9.70)p (32.31)p 9.80p
financial year
Diluted (loss)/
earnings per share
(Loss)/profit from (0.90)p (7.35)p 1.56p 0.14p 2.70p 0.12p (0.76)p (4.65)p 1.68p
discontinued
operations
(Loss)/profit for the (9.84)p (35.01)p 9.65p 0.14p 2.70p 0.12p (9.70)p (32.31)p 9.77p
financial year
Consolidated
statement of
recognised
income and expense
Foreign exchange 838 36 – (75) – – 763 36 –
gains transferred
to the consolidated
income statement
Net (loss)/gain (808) 2,317 1,515 (75) – – (883) 2,317 1,515
recognised directly in
equity
(Loss)/profit for the (5,297) (21,821) 6,518 75 1,690 80 (5,222) (20,131) 6,598
financial year
Total recognised (6,105) (19,504) 8,033 – 1,690 30 (6,105) (17,814) 8,113
income and expense
relating to the year
Attributable to equity (6,210) (19,607) 7,958 – 1,690 80 (6,210) (17,917) 8,038
shareholders
Consolidated
balance sheet
Total assets 109,617 126,738 147,157 – (236) (1,979) 109,617 126,502 145,218
Total equity 67,293 85,312 113,648 – – (1,690) 67,293 85,312 111,958
Total equity 67,067 65,425 113,800 – – (1,690) 67,067 85,425 112,110
shareholders’ funds
Source: Vodafone Group Plc, Annual Report 2009 <https://www.vodafone.com/content/annualreport/annual_report09/
downloads/VF_Annual_Report_2009.pdf>
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FINANCIAL REPORTING
Apply and Analyse 3
Based on the preceding analysis relating to All About Furniture’s change in inventory cost
flow assumption, apply the disclosure requirements of HKAS 8 and prepare the note All
About Furniture will disclose for the reporting period ended 31 December 20X4.
Analysis
The note disclosure will look as follows:
Note XX: Change in accounting policy
During 20X4, All About Furniture changed its accounting policy relating to the assumed
flow of inventory. Previously, All About Furniture used the first-in, first-out (FIFO) cost
formula. Now, All About Furniture uses the WAC formula. Management believes the WAC
formula more accurately captures inventory flow from acquisition from manufacturers to
point of sale to customers, thereby providing more relevant information about the cost of
inventories and cost of goods sold to financial statement users. In addition, the adoption
of the WAC formula is consistent with industry practice, enhancing the comparability of All
About Furniture’s financial statements.
This change in accounting policy has been accounted for retrospectively, and the
comparative statements for 20X3 have been restated. The effect of the change on
20X3 is presented below. Opening retained earnings for 20X3 have been reduced by
HK$2.38 million, which is the amount of the adjustment relating to periods prior to 20X3.
HK$’000
Profit and Retained Earnings
Effect on 20X3
(Increase) in cost of goods sold (750)
Decrease in income tax expense 124
(Decrease) in profit (626)
Effect on periods prior to 20X3
(Decrease) in profit (HK$2,850 cost of goods sold less (2,380)
income tax expense of HK$470)
(Decrease) in retained earnings as at 31 December 20X3 (3,006)
Assets and Liabilities
Effect on 20X3
(Decrease) in inventories (750)
Decrease in income tax payable 124
(Decrease) in net assets (626)
Effect on periods prior to 20X3
(Decrease) in net assets (HK$2,850 inventories reduction
less HK$470 income tax payable reduction (2,380)
(Decrease) in net assets as at 31 December 20X3 (3,006)
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Key Learning Point
It is important to identify whether a change in accounting policy has been voluntarily
undertaken by an entity or imposed by the introduction of a HKFRS and, if the latter,
whether the HKFRS contains transitional provisions because this determines whether the
change in accounting policy is within the scope of HKAS 8.
Knowledge Check Questions
Question 1
Identify which of the following is a change in accounting policy to which HKAS 8 applies.
A The application of a new accounting policy to previously immaterial transactions
B A change in the method of recognising revenue upon the adoption of HKFRS 15 Revenue
from Contracts with Customers
C The first-time adoption of the revaluation model in measuring equipment
D A change from the current and non-current to the liquidity classification of assets and
liabilities in the statement of financial position
Question 2
Identify which of the following must be disclosed by an entity for all changes in
accounting policy.
A The reasons why applying the new accounting policy provides reliable and more relevant
information
B The title of the HKFRS that caused the change in accounting policy
C The change in accounting policy is made in accordance with the transitional provisions of
the relevant HKFRS
D The nature of the change in accounting policy
Question 3
The following note disclosure relates to a change in accounting policy by LMN Limited (LMN):
Note XX: Change in accounting policy
During 20X2, LMN changed the classification of depreciation expense in the statement
of profit or loss and other comprehensive income. Previously, depreciation expense was
classified as cost of sales but is now classified as administrative expenses.
This change in accounting policy has been accounted for retrospectively, and the
comparative statements for 20X1 have been restated. The effect of the change on 20X2
is presented below. There is no effect on opening retained earnings for 20X2.
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Knowledge Check Questions (continued)
HK$’000
Profit and Retained Earnings
Effect on 20X2
Decrease in cost of sales 11,850
(In)crease in administrative expenses (11,850)
Change in profit 0
Effect on periods prior to 20X2
Decrease in cost of sales 36,191
(In)crease in administrative expenses (36,191)
Change in retained earnings as of 31 December 20X2 0
Identify which of the following describes whether this note disclosure has been prepared
in accordance with HKAS 8 disclosure requirements.
A Yes, because the nature of the change in accounting policy has been disclosed.
B No, because the reasons why the accounting policy change provides more relevant
information have not been disclosed.
C Yes, because the amount of the adjustment to each financial statement line item
affected by the accounting policy change has been disclosed.
D No, because the title of the HKFRS that caused the change in accounting policy has not
been disclosed.
1 6 . 3 ACCOUNTING ESTIMATES
Various items in financial statements can only be estimated. Estimation involves judgements
based on the latest available, reliable information. For example:
• a loss allowance for expected credit losses;
• the net realisable value of an item of inventory;
• the fair value of financial assets or financial liabilities;
• the depreciation expense for an item of property, plant and equipment; and
HKAS
8.32 • a provision for warranty obligations.
An entity may revise an accounting estimate, perhaps due to a change in circumstance on
HKAS which the estimate was based, new information becoming available that the entity can refer to,
8.34 or the entity becoming more experienced and accurate in their estimations. Such a revision
constitutes a change in accounting estimate.
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Acco u n ti n g P o l ic ies , C ha ng es in A c c o u nt ing E s t im a t es a nd Er r or s
An entity uses measurement techniques and inputs to develop an accounting estimate.
HKAS
Measurement techniques include estimation techniques (e.g., techniques used to measure
8.32A a loss allowance for expected credit losses applying HKFRS 9) and valuation techniques
(e.g., techniques used to measure the fair value of an asset or liability applying HKFRS 13).
The following section discusses how to account for a change in accounting estimate
under HKAS 8.
16.3.1 Accounting for Changes in Accounting Estimates
A change in accounting estimate is to be recognised prospectively, which means the change is
HKAS to be applied to transactions, other events and conditions from the date of the change in
8.38 estimate.
HKAS
8.38 An accounting estimate may only relate to one period or extend over multiple periods.
How to account for a change in accounting estimate depends upon whether the estimate
itself relates to one or multiple periods. The effect of a change in an accounting estimate is
included in the determination of profit or loss (by recognising it as income or an expense) in:
• The period of the change, if the change affects only one period; or
HKAS
8.36 • The period of the change and future periods if the change affects both.
To the extent that a change in an accounting estimate gives rise to changes in assets and
HKAS liabilities, or relates to an item of equity, it is recognised by adjusting the carrying amount of the
8.37 related asset, liability or equity item in the period of the change.
Illustrative Example 4
For the 20X2 reporting period, All About Furniture estimated its warranty expense
as equal to 2% of current period sales, with the percentage being derived based on
past experience (specifically, the proportion of products sold in the previous period,
being 20X1, that are returned for repair under warranty). Sales in 20X2 amounted to
HK$6,500,000. An analysis undertaken by the company revealed a dramatic increase
in the number of products returned under warranty during the 20X2 reporting period.
Because of this analysis, for the 20X3 reporting period, the company has decided to
re-estimate the warranty expense as equalling 3% of sales. Sales in 20X3 amounted to
HK$9 million. All About Furniture’s reporting period ends 31 December.
In 20X2, All About Furniture’s warranty provision totalled HK$130,000 (HK$6,500,000
2% ). Warranty claims made in relation to sales from the 20X2 reporting period totalled
HK$160,000 and are reflected in the following journal entry:
Debit Credit
HK$’000 HK$’000
Warranty provision 160,000
Cash 160,000
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FINANCIAL REPORTING
Illustrative Example 4 (continued)
In 20X3, the estimated warranty expense is HK$270,000 (HK$9 million 3%). In
accordance with HKAS 8, the increase in percentage of products sold that are expected
to be returned for repair under warranty constitutes a change in an accounting estimate.
The revised accounting estimate is to be applied prospectively, meaning that it applies to
the 20X3 reporting period and prior periods are not adjusted. The effect of the revised
estimate is included in the determination of profit or loss for the 20X3 reporting period via
the following journal entry recorded at 31 December 20X3:
Debit Credit
HK$’000 HK$’000
Warranty expense 270,000
Warranty provision 270,000
The above journal entry restores the warranty provision from an underprovision of
HK$30,000 to a credit balance of HK$240,000.
Any prior period comparative information presented in the 20X3 financial statements is
not adjusted for the change in accounting estimate.
16.3.2 Disclosure
The disclosure requirements for changes in accounting estimate differ depending upon
whether the change in accounting estimate has an effect in the current period only, or whether
the accounting estimate is expected to have an effect on future periods as well.
HKAS When a change in an accounting estimate has an effect in the current period only, an entity
8.39 is required to disclose the nature and the amount of the change.
When a change in an accounting estimate is expected to have an effect in future periods, an
entity is required to disclose the nature and the amount of the change if it is practicable to
quantify the effect of the change in future periods. When it is impracticable to quantify the
HKAS effect of the change in future periods, an entity is required to disclose the nature of the change
8.39, 40 and that it is impracticable to determine the amount of the change.
Apply and Analyse 4
As previously indicated, All About Furniture estimates its warranty provision annually
based on the proportion of last period’s products sold that were returned under warranty.
Moreover, in the previous Illustrative Example, this proportion was revised upward in 20X3
to equal 3% of sales. The note disclosure provided by All About Furniture in its financial
statements for the reporting period ended 31 December 20X3 is as follows:
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Apply and Analyse 4 (continued)
Note XX: Change in accounting estimate
Due to an increase in the number of products sold that were returned for repair under
warranty for the reporting period ended 31 December 20X2, the proportion of sales
during the current period expected to be returned for repair under warranty has been
revised upward from 2% to 3%. This revised estimate has increased the warranty
provision as of 31 December 20X3 and corresponding warranty expense by HK$90,000
for the period ended 31 December 20X3.
Determine whether the information provided by All About Furniture satisfies the
disclosure requirements of HKAS 8.
Analysis
In accordance with HKAS 8, when a change in an accounting estimate has an effect in
the current period only, an entity is required to disclose the nature and the amount
of the change. As All About Furniture estimates its warranty provision annually, the
change in accounting estimate that occurred in 20X3 only affects the current (i.e. 20X3)
reporting period.
As evident from the disclosure, a discussion of the nature of the change in accounting
estimate is provided, including the reason for the revised estimate. The amount of the
change is also quantified. Without the revised estimate, the estimated warranty expense
for the 20X3 reporting period would have been HK$180,000 (HK$9 million 2%). The
revised estimate is HK$270,000, meaning that the increase in the warranty provision
and associated warranty expense attributable to the company’s decision to revise its
accounting estimate is HK$90,000.
As such, All About Furniture complies with the disclosure requirements of HKAS 8.
Key Learning Point
In the event that an entity, when measuring a financial statement item through estimation
due to the presence of uncertainty, alters its estimation, this change in accounting estimate
is applied prospectively from the date of the change in estimate.
Knowledge Check Questions
Question 4
Wanderer Limited (Wanderer) traditionally estimates its allowance for receivables as
1% of credit sales for the year. For the year ended 31 December 20X1, credit sales were
HK$10 million. Based on this estimate, net receivables were reported as follows:
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FINANCIAL REPORTING
Knowledge Check Questions (continued)
HK$
Receivables 2,000,000
Allowance for receivables (100,000)
Net receivables 1,900,000
Bad debts written off during the current reporting period totalled HK$100,000. Due to
an expected downturn in the economy, the company has decided to estimate allowance
for receivables based on an aged analysis of receivables as at the end of each reporting
period. The aged analysis estimates the allowance for receivables should be HK$175,000 as
of 31 December 20X2. Credit sales for the reporting period ended 31 December 20X2 were
HK$12.5 million. Outstanding receivables as of 31 December 20X2 were HK$1.8 million.
Required:
Determine how Wanderer will account for the revised estimate in its allowance for
receivables for the reporting period ended 31 December 20X2.
Question 5
Based on your answer to Question 4, apply the disclosure requirements of HKAS 8 and
prepare the note Wanderer will disclose for the reporting period ended 31 December 20X2.
Question 6
Identify which of the following constitutes a change in accounting estimate.
A A change in the valuation of inventory from FIFO to the WAC method
B A change in the method of depreciating assets from a straight-line balance to a
diminishing balance
C A change in the method of recognising leases upon the adoption of HKFRS 16
D A change from the cost model to the revaluation model in accordance with HKAS 16
Question 7
On 1 July 20X1, TRA Limited (TRA) purchased machinery for HK$400,000. At the time of
acquisition, it was anticipated the machinery would have a useful life of 10 years, after
which time, it would have no residual value and would be scrapped by TRA. Due to
technological advances, on 1 July 20X2, TRA determined that the remaining useful life of
the machinery was now only eight years. Assuming TRA depreciates its machinery on a
straight-line basis, explain how TRA should account for the change in estimated useful life
of the machinery.
902
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1 6 . 4 ERRORS
An entity may make errors in respect to the recognition, measurement, presentation, or
disclosure of financial statement elements. Examples of errors include mathematical mistakes,
mistakes in applying accounting policies, oversights or misinterpretations of facts and
errors of fraud.
If these mistakes are not corrected, and are material, the financial statements will not
comply with HKRSs. Errors may be detected in the period in which occur (i.e. the current period)
and are corrected before the financial statements are authorised for issue. Other errors,
however, may not be detected until a subsequent period. These types of errors are called prior
HKAS period errors and, if material, are to be corrected in the financial statements for that
8.41 subsequent period.
Correcting an error is distinct from changing an accounting estimate. Accounting estimates
HKAS require entities to exercise judgement based on information available at the time. By their
8.48 nature, accounting estimates are approximations. As additional information becomes known,
entities may revise their approximation, giving rise to a change in an accounting estimate. This
is distinct from an error, which arises due to a failure to use or the misuse of information
available at the time.
The following section discusses how to account for the correction of a prior period error
under HKAS 8.
16.4.1 Accounting for Prior Period Errors
A material prior period error must be corrected retrospectively, which involves:
• Restating the comparative amounts for the prior period or periods presented in which
the error occurred; or
HKAS • If the error occurred before the earliest prior period presented, restating the opening
8.42 balances of assets, liabilities and equity for the earliest prior period presented.
The purpose of the above restatements is to ensure that by the commencement of the
current period, which is the period in which the error was detected, the prior period error has
HKAS been corrected. As such, the current period financial statement is presented as if the error
8.46 never occurred.
Illustrative Example 5
During the reporting period ending 31 December 20X6, All About Furniture discovered
that some products, which had been sold during the reporting period ended 31 December
20X5, were incorrectly included in inventory as of 31 December 20X5 at an amount of
HK$4.5 million.
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FINANCIAL REPORTING
Illustrative Example 5 (continued)
The following amounts are available for 20X5 (as reported) and 20X6 (draft):
20X6 20X5
HK$’000 HK$’000
Sales 61,400 51,800
Cost of goods sold (42,940) (36,280)
Profit before income taxes 18,460 15,520
Income taxes (3,046) (2,561)
Profit 15,414 12,959
The following additional information is also available:
• Retained earnings at 1 January 20X5 was HK$8,500,000;
• The cost of goods sold for 20X6 includes the HK$4,500,000 error in opening inventory;
• The income tax rate is 16.5%;
• No dividends have been declared or paid;
• The error correction has a corresponding effect on All About Furniture’s accounting
and taxable profits; and
• Assume that all amounts are material.
Applying HKAS 8, a prior period error exists as inventory was incorrectly overstated
by HK$4,500,000 for the 20X5 reporting period. Moreover, it is reasonable to presume
the prior period error is ‘material’ as the failure to correct the error could influence the
economic decisions that users make on the basis of the 20X6 financial statements.
Under HKAS 8, the prior period error is to be corrected retrospectively, which requires
All About Furniture to restate the comparative amounts for the prior period in which the
error occurred (20X5) in the financial statements of the current period (20X6), being the
period the error was detected.
Following the correction, an extract of the statement of profit or loss and other
comprehensive income for the 20X6 reporting period would look as follows:
All About Furniture
Extract from the statement of profit or loss and other
comprehensive income
(restated)
20X6 20X5
HK$’000 HK$’000
Sales 61,400 51,800
Cost of goods sold (38,440) (40,780)
Profit before income taxes 22,960 11,020
Income taxes (3,788) (1,818)
Profit 19,172 9,202
904
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Acco u n ti n g P o l ic ies , C ha ng es in A c c o u nt ing E s t im a t es a nd Er r or s
Illustrative Example 5 (continued)
Due to the error, cost of goods sold reported in 20X5 was understated, and
inventory as of 31 December 20X5 (which becomes opening inventory as of 1 January
20X6) was overstated by HK$4,500,000. Consequently, cost of goods sold in the 20X6
accounting records of All About Furniture was overstated prior to the error’s detection by
HK$4,500,000 because it includes the HK$4,500,000 error in opening inventory.
To correct for the error, cost of goods sold in 20X5 is restated upward, and inventory
is restated downward by HK$4,500,000. Due to the increase in cost of goods sold, restated
profit before income taxes is lower, as illustrated, which has two effects. First, income tax
expense and income tax payable are restated to a lower amount because fewer taxes are
payable on lower taxable profits. Second, retained earnings as of 31 December 20X5 is
lower due to a lower restated profit figure for the 20X5 reporting period.
The 20X6 accounting records are also adjusted (prior to financial statement finalisation)
by reducing cost of goods sold and increasing inventory by HK$4,500,000. As the adjustment
to the 20X6 accounting records occurred prior to finalising the financial statements, the
financial statement figures for 20X6 are presented as if the error did not occur.
Following the correction, an extract of the statement of changes in equity for the 20X6
reporting period would be as follows:
All About Furniture
Extract from the statement of changes in equity
Retained
earnings
HK$’000
Balance as of 31 December 20X4 8,500
Profit for the year ended 31 December 20X5 as restated 9,202
Balance as of 31 December 20X5 17,702
Profit for the year ended 31 December 20X6 19,172
Balance as of 31 December 20X6 36,872
In addition to the preceding adjustments, All About Furniture is required to disclose
information about the error and the financial impact of its correction, which will be
discussed further in Section 16.4.3.
16.4.2 Limitations on Retrospective Restatement
The effects of a prior period error may be unable to be determined on comparative information
for one or more prior periods presented (i.e. period-specific effects) or cumulatively to all
prior periods (i.e. the cumulative effect). For example, for one or more prior periods, it may be
impracticable to quantify the effect of a long-lasting mistake in applying an accounting policy
because of the resources an entity would need to devote to extract the relevant financial data
for each affected prior period.
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FINANCIAL REPORTING
Exhibit 16.3 outlines the restatements an entity is required to undertake when it is
HKAS 8.44,
impracticable to determine either the period-specific or the cumulative effects of a prior
45, 47 period error.
Period-specific effects Cumulative effect
Restate the opening balances Restate the comparative
of assets, liabilities and equity information to correct the error
for the earliest period for which prospectively from the earliest
retrospective restatement is date practicable (HKAS 8.45).
practicable (which could be That is, the entity disregards
the current period) (HKAS 8.44). the portion of the cumulative
restatement of assets, liabilities
and equity arising before that
date (HKAS 8.47).
EXHIBIT 16.3 Restatement requirements when
impracticable to determine either the period-specific
or the cumulative effects of a prior period error
Illustrative Example 6
Adapting the previous Illustrative Example, assume that, during the reporting period
ending 31 December 20X6, All About Furniture discovered that some products sold
during the reporting period ended 31 December 20X5 were incorrectly included in
inventory as of 31 December 20X5. Due to shortcomings in its inventory management
system, All About Furniture was unable to quantify the inventory overstatement at
the time the 20X5 financial statements were authorised for issue. Upon subsequently
implementing a new inventory management system, the amount of inventory
overstatement was calculable at HK$4.5 million.
Applying HKAS 8 to retrospectively restate financial statements to correct for a prior
period error, All About Furniture can only use information that, among other things,
would have been available when the financial statements for that prior period were
authorised for issue. Information regarding the amount of the inventory overstatement
was unavailable when the 20X5 financial statements were authorised for issue. Such
information only become available once a new inventory management system was
subsequently implemented. Based on this, it is impracticable for All About Furniture
to retrospectively correct the prior period error. In accordance with HKAS 8, the error
correction is to be applied prospectively.
Following the correction, an extract of the statement of profit or loss and other
comprehensive income for the 20X6 reporting period would look as follows:
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Acco u n ti n g P o l ic ies , C ha ng es in A c c o u nt ing E s t im a t es a nd Er r or s
Illustrative Example 6 (continued)
All About Furniture
Extract from the statement of profit or loss and other
comprehensive income
20X6 20X5
HK$’000 HK$’000
Sales 61,400 51,800
Cost of goods sold (38,440) (36,280)
Profit before income taxes 22,960 15,520
Income taxes (3,788) (2,561)
Profit 19,172 12,959
As the prior period error is to be corrected prospectively, the comparative amounts
for the prior period in which the error occurred (20X5) are not restated in the financial
statements of the current period (20X6). The 20X6 accounting records are adjusted (prior
to financial statement finalisation) to correct the error by reducing cost of goods sold and
increasing inventory, by HK$4.5 million. As the adjustment to the 20X6 accounting records
occurred prior to finalising the financial statements, the financial statement figures for
20X6 are presented as if the error did not occur.
Following the correction, an extract of the statement of changes in equity for the 20X6
reporting period would be as follows:
All About Furniture
Extract from the statement of changes in equity
Retained
earnings
HK$’000
Balance as of 31 December 20X4 8,500
Profit for the year ended 31 December 20X5 12,959
Balance as of 31 December 20X5 21,459
Profit for the year ended 31 December 20X6 19,172
Balance as of 31 December 20X6 40,631
In light of the discussion to date in this chapter, the following table in Exhibit 16.4 compares
and contrasts how to account for a change in accounting policy, a change in accounting
estimate and a prior period error in accordance with HKAS 8:
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FINANCIAL REPORTING
Change in accounting policy Change in accounting Prior period
estimate error
HKFRS HKFRS (no
(transitional transitional
provisions) provisions);
or voluntary
Accounting In accordance Retrospective Prospective application Retrospective
treatment with HKFRS application restatement
Application Refer to Adjust: (1) Included in Restate:
particular HKFRS (1) the opening determining profit or (1) the
for guidance. balance of loss in: (a) the period of comparative
each affected the change if the change amounts for
component of affects only one period; the prior period
equity for the or (b) the period of or periods
earliest prior the change and future presented in
period presented; periods if the change which the error
and affects both; and occurred; or
(2) the other (2) To the extent the (2) if the error
comparative revised estimate gives occurred before
amounts rise to changes in assets the earliest prior
disclosed for and liabilities, or relates period presented,
each prior period to an item of equity, the opening
presented. adjust the carrying balances of
amount of the related assets, liabilities
asset, liability or equity and equity for
item in the period of the the earliest prior
change. period presented.
Limitations on Refer to To the extent it To the extent it
application particular HKFRS is practicable to is practicable to
for guidance. do so. do so.
EXHIBIT 16.4 Summary of how to account for a change in accounting policy, a change in
accounting estimate and a prior period error under HKAS 8
16.4.3 Disclosure
Additional disclosures are required by HKAS 8 when correcting a material prior period error.
For corrections of prior period errors, an entity is required to disclose:
• The nature of the prior period error;
• The amount of the correction for each prior period presented to the extent practicable:
°° For each financial statement line item affected; and
°° If HKAS 33 applies, for basic and diluted EPS;
• The amount of the correction at the beginning of the earliest prior period presented;
and
• The circumstances that led to the existence of that condition and a description of how
HKAS and from when the error has been corrected if retrospective restatement is
8.49 impracticable for a particular prior period.
HKAS The disclosures are to be provided by an entity in the period in which the error is corrected.
8.49 Financial statements of subsequent periods need not repeat the disclosures.
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Acco u n ti n g P o l ic ies , C ha ng es in A c c o u nt ing E s t im a t es a nd Er r or s
Apply and Analyse 5
Based on the Illustrative Example about All About Furniture, apply the disclosure
requirements of HKAS 8 and prepare the note All About Furniture will disclose for the
reporting period ended 31 December 20X6.
Analysis
In accordance with HKAS 8, the note disclosure in the financial statements of All About
Furniture for the reporting period ended 31 December 20X6 for the correction of the
material prior period error will be presented as follows:
Note XX: Correction of prior period error
Some products sold during the reporting period ending 31 December 20X5 were
incorrectly included in inventory as of 31 December 20X5 at an amount of HK$4.5 million.
The 20X5 financial statements have been restated to correct this error. The effect of the
restatement on the 20X5 financial statements is summarised below. There is no effect for
the reporting period ending 31 December 20X6.
Effect
on 20X5
HK$’000
(Increase) in cost of goods sold (4,500)
Decrease in income tax expense 743
(Decrease) in profit (3,757)
(Decrease) in inventory (4,500)
Decrease in income tax payable 743
(Decrease) in equity (3,757)
Ethics in Practice
The choice of accounting policies to be applied to business transactions and events, the
estimations used to measure financial statements items that lack precision, and the
occurrence of material errors in recording business transactions or events all impact
an entity’s reported financial performance and financial position. In addition, each are
sensitive to judgements made about how to account for an entity’s transactions and
events and introduces discretion and subjectivity into financial reporting. For example,
to the extent an HKFRS permits choice between alternate accounting policies or does not
prescribe an accounting policy to follow, discretion exists in the selection of and change in
accounting policies. Similarly, an accounting estimate is, by its nature, subjective due to the
inherent uncertainty in the measurement of certain financial statement items.
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FINANCIAL REPORTING
Ethics in Practice (continued)
Professional judgements exercised in accounting policy choice and measurement
estimations must be done with utmost objectivity. In particular, such judgements must be
exercised to best capture the economic reality of the underlying business transaction or
event and are independent of potential pressures from management to choose accounting
policies or make accounting estimates purely to enhance financial performance and
financial position. Moreover, such objectivity extends to the immediate correction of a
prior period error upon its detection, irrespective of its financial impact.
Key Learning Point
It is fundamental to distinguish among a change in accounting policy, a change in an
accounting estimate and the correction of a prior period error because each have different
accounting and disclosure implications under HKAS 8.
Knowledge Check Questions
Question 8
Determine whether the following constitute a change in accounting policy, a change in
accounting estimate, or the detection of a prior period error:
(i) Pulp Limited acquired a conveyor system for its production process for
HK$3.5 million. At the time of acquisition, the useful life of the conveyor system
was 15 years at the end of which the conveyor system is expected to have a
residual value of HK$150,000. Because of recent technological advancements, after
two years of operation, the useful life of the conveyor system was reduced to eight
years and the residual value to nil.
(ii) ABC Limited (ABC) is a rail operator in Hong Kong. The following information was
disclosed in its 20X1 annual reports in relation to its rail assets:
Ballast is the layer of crushed rock or gravel upon which a railway track is laid, and
ballast undercutting is the renewal of this ballast that supports this track. Previously,
the ballast undercutting expenditure was charged to the statement of profit or loss.
Now, all ballast undercutting costs are capitalised as assets with a useful life of
10 years; and
(iii) During 20X4, Drew Limited (Drew) discovered that receivables to the value of
HK$10,000 that had been recognised as outstanding at 31 December 20X3 were
received from customers during 20X3.
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Acco u n ti n g P o l ic ies , C ha ng es in A c c o u nt ing E s t im a t es a nd Er r or s
Knowledge Check Questions (continued)
Question 9
During the reporting period ending 31 December 20X7, management of Atomic Limited
(Atomic) discovered an invoice processing oversight. An invoice of HK$3 million for services
provided during the reporting period ended 31 December 20X6 was incorrectly processed
during the 20X7 reporting period. At the time of processing, the amount of HK$3 million
was included as sales. At the time of detecting the error, the amount was still owing by
the customer.
The following amounts are available for 20X6 (as reported) and 20X7 (draft):
20X7 20X6
HK$’000 HK$’000
Sales 18,400 19,300
Cost of sales (2,800) (3,700)
Selling and administrative expenses (2,150) (2,690)
Profit before income taxes 13,450 12,910
Income taxes (2,219) (2,130)
Profit 11,231 10,780
The following additional information is also available:
• Retained earnings as of 1 January 20X6 was HK$7.15 million;
• The income tax rate is 16.5%;
• No dividends have been declared or paid; and
• Assume the error is material.
Required:
Applying HKAS 8, determine how Atomic will account for the prior period error for
the reporting period ended 31 December 20X7. In doing so, provide an extract of the
statement of profit or loss and other comprehensive income and the statement of changes
in equity.
Question 10
Based on your answer to Question 9, apply the disclosure requirements of HKAS 8 and
compose the note Atomic will disclose for the reporting period ended 31 December 20X7.
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SUMMARY
Accounting Policies
• An entity applies the requirements of HKAS 8 in the selection and application of accounting
policies to a transaction, other event, or condition only if no other HKFRS specifically applies to
the transaction, event, or condition.
• An entity should use its judgement in selecting and applying an accounting policy, but the
chosen policy should result in relevant and reliable information being communicated to
financial statement users.
• An entity is permitted to change an accounting policy but only if the change is required by a
newly introduced HKFRS or results in the financial statements providing reliable and more
relevant information.
• If a change in accounting policy is required by an HKFRS and the HKFRS contains transitional
provisions on the initial application of the HKFRS, an entity is required to account for the
accounting policy change in accordance with the transitional provisions.
• If a change in accounting policy is required by an HKFRS and the HKFRS does not contain
transitional provisions or the change is voluntarily undertaken to provide reliable and
more relevant information, an entity is required to apply the accounting policy change
retrospectively.
• The retrospective application of a new accounting policy is required only to the extent it is
practicable to do so. If retrospective application is impracticable, the entity is required to apply
the new accounting policy from the earliest date practicable.
Accounting Estimates
• Accounting estimates are monetary amounts in financial statements that are subject to
measurement uncertainty.
• A change in accounting estimate is to be recognised prospectively, which means the change
is to be applied to transactions, other events and conditions from the date of the change
in estimate.
• The effect of a change in an accounting estimate is required to be included in the
determination of profit or loss in the period of the change if the change affects only one
period or affects the period of the change and future periods if the change affects both.
Errors
• Should a material prior period error be detected, the error is to be corrected retrospectively
by restating comparative information contained in the financial statements of the period of
detection.
• If the entity’s financial statements contain comparative information for a prior period or
periods in which the error occurred, the entity adjusts the affected prior period comparative
amounts to correct for the error.
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Acco u n ti n g P o l ic ies , C ha ng es in A c c o u nt ing E s t im a t es a nd Er r or s
• If the error occurred before the earliest prior period for which comparative information
is provided, the entity adjusts the opening balances of assets, liabilities and equity for the
earliest prior period for which comparative information is provided to correct for the error.
• The retrospective restatement of financial statements to correct a prior period error
is required only to the extent it is practicable to do so. If retrospective restatement is
impracticable, the entity is required to restate the comparative information from the earliest
date practicable.
Disclosure Requirements
• An entity is to disclose:
°° Information about a change in accounting policy in the period the change occurs, with the
type of information to be disclosed dependent on whether the accounting policy change
was required by a HKFRS or voluntarily undertaken;
°° The nature and amount of a change in an accounting estimate except when it is
impracticable to quantify the amount, in which case the entity is required to disclose
that fact; and
°° Information about a material prior period error in the financial statements for the period
in which the error is corrected, including the nature of the error and, where practicable,
the amount of the correction.
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FINANCIAL REPORTING
MIND MAP
SCOPE OF HKAS 8 ACCOUNTING POLICIES
Applied by entities in Definition
• Selecting and applying accounting • Specific principles, bases, conventions, rules
policies; and and practices applied by an entity in preparing
• Accounting for changes in accounting and presenting financial statements
policies and accounting estimates, and Selection and Application of Accounting
corrections of prior period errors Policies
ACCOUNTING ESTIMATES • HKAS 8 applies for selecting and applying
accounting policies if no other HKFRS
Definition applies
• Accounting estimates are monetary
amounts in financial statements that Consistency of Accounting Policies
are subject to measurement uncertainty • An entity is to select and apply its
ACCOUNTING POLICIES, accounting policies consistently for similar
Accounting Treatment CHANGES IN transactions, other events and conditions
• Recognised prospectively by including the ACCOUNTING ESTIMATES
effect of the change in profit or loss in: Changes to Accounting Polices
AND ERRORS (HKAS 8)
- The period of the change, if the change • An entity can change an accounting policy if:
affects that period only; or - Mandatory, as required by a HKFRS; or
- The period of the change and future - Voluntary, if providing relevant and more
periods, if the change affects both reliable information than the existing policy
Disclosure Accounting Treatment of Changing
• An entity is to disclose the nature and Accounting Policies
amount of the change in accounting • In accordance with transitional provisions,
estimate except when impracticable to if any
quantify the amount, in which case the • If change is required by a HKFRS without
entity is to disclose that fact transitional provisions or it is a voluntary
change to the extent it is practicable
apply retrospectively
Disclosure
• An entity is to disclose information in the
PRIOR PERIOD ERRORS period the change occurs, with the type
Definition of information disclosed dependent on
• Omissions from, and misstatements in, the entity’s financial whether the accounting policy change
statements for one or more prior periods arising from a failure was required by a HKFRS or voluntarily
to use, or misuse of, reliable information undertaken
Accounting Treatment
• To the extent it is practicable, material prior period errors are
corrected retrospectively by:
- Restating the comparative amounts for the prior period(s)
presented in which the error occurred; or
- If the error occurred before the earliest prior period presented,
restating the opening balances of assets, liabilities and equity
for the earliest prior period presented
Disclosure
• An entity is to disclose information about a material prior period
error in the financial statements for the period in which the error
is corrected, including the nature of the error and, where
practicable, the amount of the correction
Answers to Knowledge Check Questions
Question 1
HKAS
Answer A is incorrect. This constitutes the selection and application of a new accounting
8.16 policy for previously immaterial transactions as opposed to a change in accounting policy.
HKAS
Answer B is incorrect. A change in the method of recognising revenue upon the adoption
8.19(a) of HKFRS 15 is dealt with under the transitional provisions of HKFRS 15.
HKAS
Answer C is incorrect. Though it is a change in accounting policy, the initial application of a
8.17 policy to revalue assets is dealt with under HKAS 16.
Answer D is correct. This represents a voluntary change in accounting policy permitted
under HKAS 1 to provide more relevant information about the entity’s financial position.
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Question 2
HKAS Answer A is incorrect. This information is required to be disclosed only for a voluntary
8.29(b) accounting change.
HKAS Answer B is incorrect. This information is to be disclosed only if the change in accounting
8.28(a) policy is required due to the initial application of a HKFRS.
HKAS Answer C is incorrect. This information is to be disclosed only if the change in accounting
8.28(b) policy is required due to the initial application of a HKFRS.
HKAS Answer D is correct. Irrespective of whether accounting change has been made voluntarily
8.28(c);
HKAS
or upon the initial application of a HKFRS, the nature of the accounting policy change shall
8.29(a) be disclosed.
Question 3
Answer A is incorrect. Though the nature of the change in accounting policy has been
HKAS disclosed by LMN in accordance with HKAS 8, that is, the reclassification of depreciation
8.29(a) expense, LMN is also required to disclose the reasons why the reclassification of
depreciation expense provides more relevant information, which it has not done.
Answer B is correct. The note disclosure does not contain the reasons why the
HKAS reclassification of depreciation expense provides more relevant information, which is a
8.29(b) disclosure requirement under HKAS 8.
Answer C is incorrect. Though the amount of the adjustment to each financial statement
HKAS line item (i.e. cost of sales; administrative expenses) affected by the reclassification of
8.29(c) depreciation expense has been disclosed, the reasons why the reclassification provides
more relevant information has not been disclosed.
Answer D is incorrect. This information is not required to be disclosed for a voluntary
accounting policy change.
Question 4
In accordance with HKAS 8, the change in the method of calculating allowance for
receivables, which was necessitated by the ongoing underestimation of the allowance in
previous years coupled with the economic downturn in the current period, constitutes
a change in an accounting estimate. The revised accounting estimate is to be applied
prospectively. As the allowance is estimated annually, prospective application means the
revised estimate will impact profit or loss in the period of change (20X2) only.
Bad debts written off during the 20X2 reporting period totalled HK$100,000 and are
reflected in the following journal entry:
Debit Credit
HK$’000 HK$’000
Allowance for receivables 100,000
Receivables 100,000
Due to the revised estimate, the balance in allowance for receivables is to become
HK$175,000. Following the bad debts write-off, the allowance for receivables has a zero
balance. The effect of the revised estimate is included in the determination of profit or loss
for the 20X2 reporting periods via the following journal entry:
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FINANCIAL REPORTING
Debit Credit
HK$’000 HK$’000
Expected credit losses 175,000
Allowance for receivables 175,000
The change in the accounting estimate is also reflected in the adjusted carrying amount
of receivables as of 31 December 20X3, demonstrated as follows:
HK$
Receivables 1,800,000
Allowance for receivables (175,000)
1,625,000
Question 5
Without the revised estimate, the desired closing balance of the allowance for receivables
for the 20X2 reporting period would have been HK$125,000 (HK$12.5 million × 1%). The
revised estimate is HK$175,000, meaning that the increase in the allowance for receivables
attributable to Wanderer’s decision to revise its accounting estimate is HK$50,000.
In accordance with HKAS 8, the note disclosure in the financial statements of Wanderer
for the reporting period ended 31 December 20X2 may be as follows:
Note XX: Change in accounting estimate
Due to an expected downturn in the economy and to prevent the potential
underestimation of debts that become bad, the allowance for receivables has been
revised upward for the current reporting period. This revised estimate has increased the
allowance for receivables as at, and corresponding expected credit losses for the period
ended 31 December 20X2 by HK$50,000.
Question 6
Answer A is incorrect. A change in inventory valuation methods constitutes a change in
accounting policy because the principle for measuring inventories has been changed.
Answer B is correct. A change in the expected pattern of consumption of the future
economic benefits embodied in depreciable assets, thereby necessitating a change from
HKAS the straight-line balance method to the diminishing balance method, constitutes a change
8.32 in accounting estimate. In addition, when distinguishing between a change in accounting
HKAS policy and a change in accounting estimate is difficult, the change is treated as a change in
8.35 accounting estimate.
HKAS Answer C is incorrect. A change in the method of recognising leases upon the adoption of
8.14 HKFRS 16 is a change in accounting policy required by a HKFRS.
HKAS Answer D is incorrect. The initial application of a policy to revalue assets in accordance with
8.17 HKAS 16 is a change in accounting policy.
916
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Question 7
The change in accounting estimate has been applied prospectively to the current and
future periods. The revised depreciation expense is calculated as follows: Carrying amount
at time of change in estimate/Remaining useful life (i.e. HK$360,000/8 years = HK$45,000).
Question 8
(i) Changes to the estimated useful life and residual value of the conveyor system
constitute a change in the accounting estimate under HKAS 8 because the changes
arose from a reassessment of the expected future benefits to be derived from the
use of the conveyor system in light of recent technological developments.
(ii) The information disclosed by ABC represents a change in accounting policy.
Previously, the practice applied by ABC was to expense all undercutting
expenditure. Now, such expenditure is capitalised, which represents a change in
the practice applied by ABC in accounting for undercutting expenditure.
(iii) A prior period error has been detected by Drew because receivables have been
incorrectly overstated (as of 31 December 20X3) due to the failure to record cash
received from customers during 20X3. This error was discovered in 20X4.
Question 9
Applying HKAS 8, a prior period error exists because revenue earned in the 20X6 reporting
period was incorrectly recorded as sales in the 20X7 reporting period.
Under HKAS 8, the prior period error is to be corrected retrospectively, which requires
Atomic to restate the comparative amounts for the prior period in which the error
occurred (20X6) in the financial statements of the current period (20X7), being the period
the error was detected.
Following the correction, an extract of the statement of profit or loss and other
comprehensive income for the 20X7 reporting period would look as follows:
Atomic
Extract from the statement of profit or loss and
other comprehensive income
(restated)
20X7 20X6
HK$’000 HK$’000
Sales 15,400 22,300
Cost of sales (2,800) (3,700)
Selling and administrative expenses (2,150) (2,690)
Profit before income taxes 10,450 15,910
Income taxes (1,724) (2,625)
Profit 8,726 13,285
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FINANCIAL REPORTING
Due to the error, sales and receivables reported in 20X6 were understated by
HK$3 million. In addition, sales in the 20X7 accounting records of Atomic was overstated
prior to the error’s detection by HK$3 million because it includes the HK$3 million earned
in the prior period.
To correct for the error, sales and receivables are restated upward for the 20X6
reporting period by HK$3 million. Due to the restatement of sales, restated profit before
income taxes is higher, as illustrated, resulting in the restated figures for income tax
expense, income tax payable, and retained earnings (as of 31 December 20X3) also
being higher.
The 20X7 accounting records are also adjusted (prior to financial statement finalisation)
by reducing sales and receivables by HK$3 million to avoid double counting the same
invoice. As the adjustment to the 20X7 accounting records occurred prior to finalising the
financial statements, the financial statement figures for 20X7 are presented as if the error
did not occur.
Following the correction, an extract of the statement of changes in equity for the 20X7
reporting period would be as follows:
Atomic
Extract from the statement of changes in equity
Retained
earnings
HK$’000
Balance as of 31 December 20X5 7,150
Profit for the year ended 31 December 20X6 as restated 13,285
Balance as of 31 December 20X6 20,435
Profit for the year ended 31 December 20X7 8,726
Balance as of 31 December 20X7 29,161
Question 10
In accordance with HKAS 8, the note disclosure in the financial statements of Atomic for
the reporting period ended 31 December 20X7 for the correction of the material prior
period error will look as follows:
Note XX: Correction of prior period error
An invoice for services performed during the reporting period ending 31 December
20X6 was processed during the 20X7 reporting period, resulting in HK$3,000,000 being
incorrectly recorded as sales in 20X7 rather than in 20X6. The 20X6 financial statements
have been restated to correct this error. The effect of the restatement on the 20X6
financial statements is summarised in the following. There is no effect for the reporting
period ending 31 December 20X7.
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Acco u n ti n g P o l ic ies , C ha ng es in A c c o u nt ing E s t im a t es a nd Er r or s
Effect
on 20X6
HK$’000
Increase in sales 3,000
(Increase) in income tax expense (495)
Increase in profit 2,505
Increase in receivables 3,000
(Increase) in income tax payable (495)
Increase in equity 2,505
EXAM PRACTICE
QUESTION 1
Luxury Experience Limited (Luxury) owns and operates a premium hotel with an
accompanying restaurant in Hong Kong. During the reporting period ending 31 December
20X7, the following events occurred:
• Kitchen equipment: Management decided to revise the useful life of its kitchen
equipment due to wear and tear. The equipment was purchased on 1 January 20X3
at a cost of HK$1.5 million. At the time of acquisition, the estimated useful life of
the equipment was 10 years and the residual value HK$175,000. The remaining
useful life is now estimated to be five years, commencing 1 January 20X7. Estimated
residual value is unchanged. Luxury depreciates its kitchen equipment on a
straight-line basis;
• Receipt oversight: Management discovered a receipt processing oversight. PD Value
Ltd (PDV) is a corporate customer whose sales executives use the hotel and the
restaurant to entertain clients. PDV is entitled to settle its account on a quarterly
basis. An invoice of HK$250,000 was issued for the quarter ended 30 September
20X6, being recorded as sales at the time of issue. PDV has 90 days to settle the
invoice. The amount of HK$250,000 was incorrectly recorded as outstanding as at
31 December 20X6, when in fact PDV had settled the invoice on 30 December 20X6.
The receipt had not been processed at the time of the detection of the mistake; and
• Investment property: It was decided that, to provide more relevant information in
Luxury’s financial statements, its sole investment property should be accounted
for using the fair value model per HKAS 40 Investment Property. Previously, Luxury
elected to apply the cost model per HKAS 40 to account for the investment
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FINANCIAL REPORTING
property, adopting a 50-year useful life and estimated residual value of
HK$45 million. The change is to apply from 31 December 20X7. The investment
property was acquired on 1 January 20X5 for HK$195,000,000. The property had a
fair value of HK$199 million, HK$202 million and HK$207 million on 31 December
20X5, 20X6 and 20X7, respectively.
The following amounts are available for 20X6 (as reported) and 20X7 (draft, before: (i)
accounting for depreciation; and (ii) implementing each of the preceding bullet points):
Luxury Experience
Statement of profit or loss and other comprehensive income
20X7 20X6
HK$’000 HK$’000
Sales 26,350 21,480
Cost of sales (3,890) (2,910)
Selling and administrative expenses, including depreciation (6,210) (5,690)
Profit before income taxes 16,250 12,880
Income taxes (2,681) (2,125)
Profit 13,569 10,755
Luxury Experience
Statement of Financial Position
20X7 20X6
HK$’000 HK$’000
Cash at bank 3,910 3,240
Receivables, net 1,650 1,720
Property, plant and equipment 11,150 10,780
Accumulated depreciation and impairment losses (1,850) (1,410)
Property, plant and equipment, carrying amount 9,300 9,370
Investment property 195,000 195,000
Accumulated depreciation and impairment losses (6,000) (6,000)
Investment property, carrying amount 189,000 189,000
The following additional information is also available:
• Retained earnings as of 1 January 20X6 is HK$5.85 million;
• The income tax rate is 16.5%;
• No dividends have been declared or paid; and
• Assume all amounts are material.
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Acco u n ti n g P o l ic ies , C ha ng es in A c c o u nt ing E s t im a t es a nd Er r or s
Required:
(a) Advise the management of Luxury on the accounting treatment of each of the
preceding events.
(b) Incorporate your recommended accounting treatment for each of the preceding events
and prepare an extract of:
• The statement of profit or loss;
• The statement of financial position; and
• The statement of changes in equity
for the year ended 31 December 20X7.
(c) Compose the note(s) Luxury will disclose for the reporting period ended 31 December
20X7 for each of the preceding events.
QUESTION 2
(Adapted from Question 5 of Module A June 2017 Paper)
Maximus Limited (Maximus) is a manufacturer of hybrid vehicles. On 1 January 20X4,
Maximus purchases an item of machinery that would reduce its greenhouse gas emissions
from its production process by 20%. The machinery is acquired from a Singaporean supplier
at a cost of S$200,000. At the time of purchase, S$1 equals HK$6. As of 31 December 20X4,
S$1 equals HK$5.50. The machinery has an expected useful life of four years, and it is
expected the machinery will contribute equally to the production of hybrid vehicles in each
of these four years. Maximus accounts for its machinery using the cost model. Due to a
recent government initiative, Maximus received a tax-free government grant of HK$1 million
to subsidise the purchase. The grant, however, is conditional on certain production targets
being achieved within the next two years. Upon receiving the grant, Maximus expects to
meet the stipulated production targets.
Assume an income tax rate of 16.5%.
Required:
Advise Maximus’s management as to the accounting implications in the financial statements
for the year ended 31 December 20X5 if:
(a) Maximus recognised the purchase of the machinery as cost of sales in the financial
statements for the year ended 31 December 20X4; and
(b) Maximus recognised the entire subsidy as income in the financial statements for the
year ended 31 December 20X4.
ANSWERS TO EXAM PRACTICE
QUESTION 1
(a) Kitchen equipment
Under HKAS 8.5, determining the expected useful life of the kitchen equipment is an
accounting estimate given judgement has been exercised in estimating the expected
time the kitchen equipment will be used. A revision of this expected time period,
therefore, constitutes a change in an accounting estimate under HKAS 8.32(c).
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FINANCIAL REPORTING
Under HKAS 8.36, the effect of a change in accounting estimate is to be recognised
prospectively. Prior to the revised estimate, the annual depreciation charge is
HK$132,500 ((HK$1,500,000 – HK$175,000)/10 years), and the carrying amount of the
kitchen equipment as of 31 December 20X6 is:
HK$
Cost 1,500,000
Accumulated depreciation (530,000)
970,000
The revised estimate results in an annual depreciation charge of HK$159,000
((HK$970,000 – HK$175,000)/5 years). Under HKAS 8.37, after applying the change in
accounting estimate the adjusted carrying amount of the kitchen equipment as of
31 December 20X7 is:
HK$
Cost 1,500,000
Accumulated depreciation (689,000)
811,000
Because the change in the accounting estimate is to be applied prospectively,
restatement of the 20X6 financial statements is not required.
Receipt oversight
Under HKAS 8.5, the incorrect recognition of HK$250,000 as receivables rather than
cash received constitutes a prior period error because it could reasonably be expected
that Luxury was aware that HK$250,000 was no longer outstanding and, therefore,
should have been accounted for as such in the preparation and presentation of its 20X6
financial statements.
Under HKAS 8.42, the error is to be corrected retrospectively by restating cash
at bank (receivables) is restated upward (downward) as of 31 December 20X6 by
HK$250,000. There is no impact on profit because sales was correctly recorded at the
time the invoice was issued.
No adjustment is required to the figures presented in the 20X7 draft financial
statements because the receipt has not been recorded at the time of the error
detection and the 20X7 financial statements are presented as if the error did not occur.
Investment property
HKAS 40 Investment Property allows investment property to be measured using the cost
model or the fair value model. Under HKAS 8.5, because the cost and fair value models
are bases used in the measurement of investment property, they constitute accounting
policies. A change from the cost model to the fair value model is, therefore, a change in
accounting policy under HKAS 8.5.
Under HKAS 8.19(b), a voluntary change in accounting policy is to be applied
retrospectively by restating its financial statements as if the fair value model has always
been in effect (post-initial measurement at cost).
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Acco u n ti n g P o l ic ies , C ha ng es in A c c o u nt ing E s t im a t es a nd Er r or s
Under HKAS 8.22, Luxury is to restate the opening balance of retained earnings for
the earliest prior period presented (20X6) for the change in fair value of investment
property up to 1 January 20X6. Luxury must also restate relevant comparative amounts
disclosed for each prior period presented (20X6) to recognise the change in fair value
during the 20X6 reporting period.
The necessary adjustments are calculated as follows:
Cost model Fair value Adjustment
model
HK$’000 HK$’000 HK$’000
Carrying amount as of 1 January 20X5 195,000 195,000
Profit or loss for 20X5 reporting period (3,000) 4,000 7,000
Carrying amount as of 31 December 20X5 192,000 199,000
Profit or loss for 20X6 reporting period (3,000) 3,000 6,000
Carrying amount as of 31 December 20X6 189,000 202,000
Profit or loss for 20X7 reporting period Depreciation 5,000 5,000
not yet
accounted for
Carrying amount as of 31 December 20X7 207,000
(b) Extracts from the financial statements for the 20X7 reporting period are as follows:
Luxury Experience
Extract from the statement of profit or loss
20X7 20X6
(restated)
HK$’000 HK$’000
Sales 26,350 21,480
Cost of sales (3,890) (2,910)
Gain on re-measurement of investment property 5,000 a
3,000a
Selling and administrative expenses, including depreciation (6,369)b (2,690)a
Profit before income taxes 21,091 18,880
Income taxes (3,480) (3,115)
Profit 17,611 15,765
Luxury Experience
Extract from the Statement of Financial Position
20X7 20X6
(restated)
HK$’000 HK$’000
Cash at bank 3,910 3,490c
Receivables, net 1,650 1,470c
Property, plant and equipment 11,150 10,780
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FINANCIAL REPORTING
Luxury Experience
Extract from the statement of profit or loss
20X7 20X6
(restated)
HK$’000 HK$’000
Accumulated depreciation and impairment losses (2,009) b
(1,410)
Property, plant and equipment, carrying amount 9,141 9,370
Investment property 207,000 a
202,000a
Luxury Experience
Extract from the Statement of Changes in Equity
Retained
earnings
HK$’000
Balance as of 31 December 20X5 as previously reported 5,850
Change in accounting policy for the shift from the cost model to the fair 5,845a
value model in measuring investment property (net of income taxes of
HK$1.155 million)
Balance as as of 31 December 20X5 as restated 11,695
Total comprehensive income for the year ended 31 December 20X6 as 15,765
restated
Balance as as of 31 December 20X6 27,460
Total comprehensive income for the year ended 31 December 20X7 17,611
Balance as as of 31 December 20X7 45,071
a
or 20X6, restate the statement of profit or loss by including HK$3 million (HK$202,000,000 –
F
HK$199 million) as a gain and reducing depreciation expense by HK$3 million. Investment property is
restated in the statement of financial position to HK$202 million. For 20X7, update the draft statement of
profit or loss by including HK$5 million (HK$207 million – HK$202 million) as a gain. Investment property
is recognised in the statement of financial position at HK$207 million. Pre-20X6, retained earnings as of
31 December 20X5 are restated upward for HK$7 billion (HK$199 million – HK$192 million). After tax, the
increase in retained earnings as of 31 December 20X5 is HK$5.845 million.
b
Includes revised depreciation expense of HK$159,000.
c
estate cash at bank (receivables) upward (downward) by HK$250,000 relative to the original 20X6 reported
R
amount.
(c) Kitchen equipment
Note XX: Change in accounting estimate
Due to advanced wear and tear, the estimated useful life of kitchen equipment has
been revised downward for the current reporting period and each future reporting
period for the remaining four years of the kitchen equipment’s estimated useful life.
This revision has increased depreciation expense for the period ended 31 December
20X7 and will increase depreciation expense by HK$26,500 for each future reporting
period up to 31 December 20X1.
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Acco u n ti n g P o l ic ies , C ha ng es in A c c o u nt ing E s t im a t es a nd Er r or s
Receipt oversight
Note XX: Correction of prior period error
Cash received by a customer during the previous reporting period was incorrectly
recorded as outstanding as of 31 December 20X6, resulting in HK$250,000 being
incorrectly recorded as receivables in 20X6. The 20X6 financial statements have been
restated to correct this error. The effect of the restatement on the 20X6 financial
statements is summarised below. There is no effect for the reporting period ending
31 December 20X7.
Effect on
20X6
HK$’000
Increase in cash at bank 250
(Decrease) in receivables (250)
Investment property
Note XX: Change in accounting policy
During 20X7, Luxury changed its accounting policy relating to the measurement of its
investment property. Previously, Luxury used the cost model. Now, Luxury uses the
fair value model. Management believes the fair value model will provide more relevant
information about the value of its investment property than the cost model.
This change in accounting policy has been accounted for retrospectively, and the
comparative statements for 20X6 have been restated. The effect of the change on
20X6 is presented below. Opening retained earnings for 20X6 have been increased
by HK$5.845 million, which is the amount of the adjustment relating to periods
prior to 20X6.
HK$’000
Effect on 20X6
Increase in gain on re-measurement of investment property 3,000
Decrease in depreciation expense 3,000
(Increase) in income tax expense (990)
Increase in total comprehensive income 5,010
Effect on periods prior to 20X6
Increase in total comprehensive income (HK$7 million gain on 5,845
re-measurement of investment property less tax of HK$1.15 million)
Increase in retained earnings as of 31 December 20X6 10,855
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FINANCIAL REPORTING
QUESTION 2
(a) Given the purchase relates to a depreciable asset, the cost of the machinery should be
capitalised and depreciated over the estimated useful life of the machinery. As such, if
Maximus recognised the purchase of the machinery as an expense for the year ended
31 December 20X4, it is considered to be an error.
In accordance with HKAS 8.42, Maximus is to correct the error retrospectively in
the first set of financial statements authorised for issue after its discovery (i.e. the
year ended 31 December 20X5 assuming this is the period during which the error was
discovered) by restating the comparative amounts for the prior period presented.
The comparative amounts are to be restated using the exchange rate at the time of
purchase (i.e. S$1 equals HK$6).
In particular, in relation to the statement of profit or loss and other comprehensive
income for the year ended 31 December 20X4, Maximus is to:
• Decrease cost of sales by HK$1.2 million (S$200,000 HK$6);
• Increase depreciation expense by HK$300,000 (HK$1.2 million/4 years);
• Increase income tax expense by HK$148,500 (net increase in pre-tax profit of
HK$900,000 16.5%); and which, overall, results in an
• Increase in after-tax profit of HK$751,500.
In relation to the statement of financial position as of 31 December 20X4, Maximus
is to:
• Increase property, plant and equipment by HK$1.2 million;
• Increase accumulated depreciation on property, plant and equipment by
HK$300,000;
• Increase income tax payable by HK$148,500; and
• Increase retained earnings by HK$751,500.
Maximus shall also disclose the information required by HKAS 1.41 to HKAS 1.44
and HKAS 8.49. In particular, Maximus shall disclose:
• The nature of the prior period error; and
• The amount of the correction for each financial statement line item
affected for 20X4.
To illustrate:
Note XX: Correction of prior period error
The purchase of machinery costing HK$1.2 million was incorrectly recorded as cost of
sales in 20X4. The 20X4 financial statements have been restated to correct this error.
The effect of the restatement on the 20X4 financial statements is summarised below.
There is no effect for the reporting period ending 31 December 20X5.
926
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Acco u n ti n g P o l ic ies , C ha ng es in A c c o u nt ing E s t im a t es a nd Er r or s
Effect on
20X4
HK$’000
Decrease in cost of sales 1,200
(Increase) in depreciation expense (300)
(Increase) in income tax expense (149)
Increase in profit 751
Increase in property, plant and equipment 1,200
(Increase) in accumulated depreciation (300)
(Increase) in income tax payable (149)
Increase in equity 751
(b) Given the government grant relates to a depreciable asset, the grant should be
recognised as income over the useful life of the machinery (i.e. four years) consistent
with the pattern of use of the machinery (i.e. on a straight-line basis). If Maximus
recognises the entire government grant as income in the year ended 31 December
20X4, it is considered to be an error.
Maximus is to correct the error retrospectively in the first set of financial statements
authorised for issue after its discovery by restating the comparative amounts for the
prior period presented.
In particular, in relation to the statement of profit or loss and other comprehensive
income for the year ended 31 December 20X4, Maximus is to decrease other income by
(1 million 3/4) = HK$750,000; which results in a decrease in profit by HK$750,000.
In relation to the statement of financial position as of 31 December 20X4, Maximus is to:
• Increase deferred grant income by HK$750,000; and
• Decrease retained earnings by HK$750,000.
Maximus shall also disclose the Information required by HKAS 1.41 to HKAS 1.44
and HKAS 8.49. In particular, Maximus shall disclose:
• The nature of the prior period error; and
• The amount of the correction for each financial statement line item affected for 20X4.
To illustrate:
Note XX: Correction of prior period error
A government grant of HK$1 million received to subsidise the purchase of machinery
in 20X4 was incorrectly recognised as income in full upon receipt rather than over
the useful life of the machinery. The 20X4 financial statements have been restated
to correct this error. The effect of the restatement on the 20X4 financial statements
is summarised in the following. There is no effect for the reporting period ending
31 December 20X5.
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FINANCIAL REPORTING
Effect on
20X4
HK$’000
(Decrease) in other income (750)
(Decrease) in profit (750)
(Increase) in deferred grant income (750)
(Decrease) in equity (750)
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17
Events after the
Reporting Period
CHAPTER TOPIC LIST
17.1 Overview 17.3 Disclosure
17.1.1 Scope of HKAS 10 17.3.1
Date of Authorisation
17.1.2 Terminology for Issue
17.2 Recognition and Measurement 17.3.2
Updating Disclosure about
Conditions at the End of
17.2.1
Adjusting Events after the
the Reporting Period
Reporting Period
17.3.3
Non-adjusting Events after
17.2.2
Non-adjusting Events after
the Reporting Period
the Reporting Period
17.2.3 Going Concern 17.4 Application of HKAS 10
17.2.4 Dividends
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FINANCIAL REPORTING
LEARNING OUTCOMES
PRINCIPAL LO3: EVALUATE AND ADVISE ON APPROPRIATE ACCOUNTING PRINCIPLES TO ACCOUNT
FOR COMPLEX BUSINESS TRANSACTIONS
LO3.09: A
ccount for, evaluate and advise on business transactions in accordance with Hong Kong
Financial Reporting Standards as they relate to: Events after the Reporting Period
3.09.01 Explain the period during which there is responsibility for reporting events
3.09.02 Account for adjusting and non-adjusting events
3.09.03 Explain when the financial statements should be prepared on a basis other than
going concern
3.09.04 Advise on the appropriate accounting adjustments in respect of adjusting events
3.09.05 Prepare and appraise disclosure in respect of events after the reporting period
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Events after the R eporting P eriod
OPENING CASE
SUPREME BAKERY LIMITED
S upreme Bakery Limited (Supreme) is a retail company offering a full range of sweet and
savoury baked goods, including bread, tarts and cakes. It has a chain of 20 franchisee
bakeries throughout Hong Kong and mainland China.
Supreme owns a plant in both Hong Kong and mainland China where the ingredients are
stored and the goods are baked using a fully automated baking process. Supreme has four
delivery trucks at each plant, which are loaded on a daily basis to deliver the freshly baked
goods to the 20 bakeries.
Supreme sources the ingredients for the baked goods from various local suppliers that
deliver their respective ingredients to Supreme’s plant on a weekly basis. Once delivered, the
ingredients are stored in a climate-controlled storage area until the baking process begins.
The climate-controlled environment is set to ensure the temperature and humidity of the
storage area complies with government food safety standards.
Supreme’s reporting period ends 31 December 20X4, and the financial statements for the
20X4 reporting period are anticipated to be authorised for issue on 31 March 20X5.
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FINANCIAL REPORTING
OVERVIEW
Financial statements are prepared by entities to present the financial performance of the entity
over a specified period (i.e. the reporting period), and the financial position of the entity as at
the last day of the reporting period. There is, however, a delay between the end of the reporting
period and when the financial statements are completed and made available to users.
Between the end of the reporting period and the financial statements being authorised
for issue to users, business and economic events may occur that clarify how items within the
financial statements should have been measured at the end of the reporting period. These
types of events are called adjusting events. Alternatively, business and economic events may
occur that relate to circumstances that occur after the end of the reporting period but, when
material, an entity must disclose information about these events in its financial statements
in the interest of full disclosure and to ensure its financial statement users are able to make
informed economic decisions. These are called non-adjusting events.
This chapter addresses the accounting treatment of adjusting and non-adjusting events.
Initially, you should gain an understanding of the time window during which adjusting and
non-adjusting events can occur. Subsequently, you should gain an understanding of how to
distinguish between adjusting and non-adjusting events and how an entity is to account for
adjusting and non-adjusting events. In particular, by the end of this chapter, you should gain an
understanding of how an entity is to recognise adjusting events in its financial statements and
the types of information to disclose in relation to events after the reporting period. You should
also have an understanding that adjusting and non-adjusting events may cause the going
concern assumption to be violated.
1 7 . 1 OVERVIEW
This chapter examines when an entity should adjust its financial statements for events that
occur after the end of the reporting period, but before the date when the financial statements
are authorised to be issued. The accounting treatment of events that occur within this time
window is governed by HKAS 10 Events after the Reporting Period.
The objective of HKAS 10 is to:
• Prescribe when an entity should adjust its financial statements for events after the
reporting period;
• Prescribe the disclosures that an entity should give about the date when the financial
statements were authorised for issue and about events after the reporting period; and
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Events after the R eporting P eriod
• Prohibit an entity from preparing its financial statements on a going concern basis if
HKAS events after the reporting period indicate that the going concern assumption is
10.1 inappropriate.
17.1.1 Scope of HKAS 10
HKAS 10 is to be applied by entities in the accounting for, and the disclosure of, events that
HKAS occur after the end of the reporting period but before the financial statements that relate to
10.2 the reporting period are authorised for issue.
Exhibit 17.1 depicts the time window to which HKAS 10 applies:
End of reporting period Authorisation date
Reporting Period Period that HKAS 10 applies to
EXHIBIT 17.1 Scope of HKAS 10
Events that occur outside the period between the end of the reporting period and the
authorisation date for financial statements to be issued are governed by relevant other HKASs
and HKFRSs.
17.1.2 Terminology
HKAS 10 defines events after the reporting period as those favourable or unfavourable
HKAS events that occur between the end of the reporting period and the date when the financial
10.3 statements are authorised for issue (Exhibit 17.2).
End of reporting period Authorisation date
Reporting Period Period that HKAS 10 applies to
Adjusting events Non-adjusting events
Those providing Those indicative of
evidence of conditions conditions that arose
existing at the end of after the end of the
the reporting period reporting period
EXHIBIT 17.2 Types of events after the reporting period
Having defined what events after the reporting period are, HKAS 10 classifies them into
two types:
1. Those that provide evidence of conditions that existed at the end of the reporting
period, which HKAS 10 calls ‘adjusting events after the reporting period’; and
HKAS 2. those that are indicative of conditions that arose after the reporting period, which
10.3 HKAS 10 calls ‘non-adjusting events after the reporting period’.
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FINANCIAL REPORTING
HKAS 10 acknowledges that the process in authorising the financial statements for issue
HKAS will vary from entity to entity. As such, the date when the financial statements are authorised
10.4 for issue is dependent on an entity’s authorisation process.
HKAS 10 provides the following examples of an entity’s authorisation process to assist in
identifying when the date of authorisation occurs:
• When an entity is required to submit its financial statements to its shareholders for
approval after the financial statements are issued, the authorisation date is the same as
the date of issue (and not the later date of shareholder approval); and
• When management of an entity is required to issue its financial statements to a
non-executive supervisory board for approval, the authorisation date is the date on
HKAS which management authorises the financial statements for issue to the supervisory
10.5–6 board (and not the later date of supervisory board approval).
After the end of the reporting period, but prior to financial statements being authorised for
issue, an entity may publicly release selected financial information relating to the reporting
period. Events that occur between the public release of this information and the date when the
HKAS financial statements are authorised for issue are still considered events after the reporting
10.7 period for HKAS 10 purposes.
Apply and Analyse 1
Prime Location Ltd (Prime Location) is a realtor whose reporting period ends 31 December
20X3. On 1 February 20X4, Prime Location issues a media release with preliminary profit
figures for the reporting period. On 8 March 20X4, the management of Prime Location
authorises the financial statements for the reporting period ending 31 December 20X3 be
issued to its non-executive supervisory board. After reviewing the financial statements, the
supervisory board approves them on 19 March 20X4. The financial statements are made
available to shareholders and the general public on 25 March 20X4, with the shareholders
approving of the financial statements at the annual general meeting held on 30 April 20X4.
The financial statements are then filed with the Companies Registry on 10 May 20X4.
Identify the time period within which events after the reporting period may occur for
Prime Location.
Analysis
HKAS 10 applies to those events that occur between the end of the reporting period and
the date the financial statements are authorised for issue. The end of the reporting period
is 31 December 20X3. In accordance with HKAS 10, the date of authorisation is 8 March
HKAS 20X4 as this is the date management authorises the financial statements for issue to the
10.6 supervisory board. As such, if an event occurs between 31 December 20X3 and 8 March
20X4, Prime Location must apply HKAS 10. Any events that occur outside this time period
are beyond the scope of HKAS 10.
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Events after the R eporting P eriod
Knowledge Check Questions
Question 1
Management of Chap Pty Ltd (Chap) completes draft financial statements for the year
ended 31 December 20X8 on 15 February 20X9. On 1 March 20X9, management of
Chap issue a media release announcing preliminary profit figures for the year ended
31 December 20X8. The following day, the board of directors reviews the financial
statements and authorises them for issue. The financial statements are placed on Chap’s
website for shareholders and others to access on 28 March 20X9. Shareholders approve
the financial statements at the annual general meeting on 31 May 20X9.
Identify the time period within which HKAS 10 will apply to any events that might occur
to Chap.
A 31 December 20X8 – 15 February 20X9
B 31 December 20X8 – 1 March 20X9
C 31 December 20X8 – 2 March 20X9
D 31 December 20X8 – 31 May 20X9
1 7 . 2 RECOGNITION AND MEASUREMENT
Whether an entity should recognise the accounting consequences of events after the reporting
period in the financial statements relating to that reporting period depends on the type of
event that occurs.
17.2.1 Adjusting Events after the Reporting Period
HKAS An entity shall adjust amounts recognised in its financial statements to reflect adjusting events
10.8 after the reporting period.
An entity may engage in transactions, dealings or arrangements during the period that are
yet to be finalised by the end of a reporting period. As these are incomplete at the end of the
reporting period, there may be uncertainty in their recognition and measurement at reporting
period-end. An adjusting event after the reporting period adds to an entity’s understanding
of, and provides clarity in, how it should have recognised and measured these transactions at
reporting period-end. As such, HKAS 10 requires the entity to change amounts recognised or
to recognise amounts that were not previously recognised in its financial statements in light of
this additional information.
The following are examples of adjusting events after the reporting period that require an
entity to adjust the amounts recognised in its financial statements or to recognise items that
were not previously recognised:
• The settlement after the reporting period of a court case that confirms the entity had a
present obligation at the end of the reporting period;
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• The bankruptcy of a customer that occurs after the reporting period confirming the
customer was credit-impaired at the end of the reporting period;
• The sale of inventories after the reporting period at an amount below cost, which
confirms that inventories were overstated at the end of the reporting period;
• The determination after the reporting period of the cost of assets purchased or the
proceeds of asset sold before the end of the reporting period;
• The determination after the reporting period of the amount of profit-sharing or bonus
payments, if a present obligation existed at the end of the reporting period to make
such payments; and
HKAS
10.9 • The discovery of fraud or errors that show the financial statements are incorrect.
Illustrative Example 1
On 10 January 20X5, the purchasing manager of Supreme discovers an invoice from
Fresh Produce Limited (Fresh Produce), Supreme’s main supplier of eggs. The eggs
(as well as the accompanying invoice) were delivered by Fresh Produce on 30 December
20X4, and Supreme had not begun the baking process as at 31 December 20X4. Prior
to its discovery, the purchasing department had not processed the invoice, which totals
HK$75,000.
In general, events that occur during the 20X4 reporting period (i.e. from 1 January –
31 December 20X4) are to be recorded by Supreme for the 20X4 reporting period. For
events that occur between the end of the reporting period (i.e. 31 December 20X4) and the
date when the financial statements are authorised for issue (i.e. 31 March 20X5), HKAS 10
applies and Supreme must determine whether the event in question is an adjusting or
non-adjusting event.
The discovery of the invoice is an adjusting event because it provides Supreme with
information on conditions that existed at the end of the reporting period. Supreme
purchased and took delivery of the eggs during the 20X4 reporting period, which were
still on hand as of 31 December 20X4. The discovery of an invoice, which had not been
recorded by Supreme, for a purchase that occurred during 20X4, sheds light on conditions
that arose during the reporting period. As such, it is an adjusting event.
In accordance with HKAS 10, Supreme should adjust recognised amounts in the
financial statements for the 20X4 reporting period. To do this, Supreme would record
the following journal entry for the end of the 20X4 reporting period (i.e. entry made on
10/1/20X5 for the year ended on 31 December 20X4):
Debit Credit
HK$ HK$
Inventory – raw materials 75,000
Accounts payable 75,000
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Apply and Analyse 2
On 15 January 20X4, an employee of Supreme suffered a personal injury while working at
Supreme’s plant in mainland China. As a consequence of the injuries, the employee was
no longer able to work. On 1 November 20X4, the former employee commenced legal
action against Supreme, claiming the injury was caused by an unsafe work environment.
At 31 December 20X4, the former employee was undergoing an independent medical
assessment to verify the severity of the injuries sustained, while an independent
assessment of Supreme’s work practices was also being undertaken to determine the
cause of the personal injury. Both sets of findings were released on 1 February 20X5,
with the medical assessment finding the former employee’s injury was severe and
the independent assessment of Supreme’s work practices concluding that Supreme
contributed to the former employee’s injury. On the same day, Supreme reached an
out-of-court settlement with the former employee, and agreed to pay damages of HK$5
million. The amount was payable within 120 days.
Determine how Supreme should account for the settlement of the personal injury claim.
Analysis
The settlement of the personal injury claim is an adjusting event because it provides
Supreme with evidence in relation to a condition that existed at the end of the reporting
period. The injury and the commencement of the legal action occurred during the 20X4
reporting period, with the claim yet to be resolved at the end of the reporting period. The
settlement of the personal injury claim sheds light on conditions that arose during the
reporting period and, as such, it is an adjusting event.
As at 31 December 20X4, it is yet to be established whether Supreme is liable for
damages because the cause of the injury is yet to be determined. In addition, the amount
of potential damages payable cannot be reliably estimated as the former employee is still
undergoing a medical assessment to determine the extent of injuries suffered. As such,
on 31 December 20X4, Supreme would have accounted for the personal injury claim as a
contingent liability.
Upon both sets of findings being released on 1 February 20X5, Supreme is apparently
liable to pay damages. Moreover, the medical assessment enables the amount payable to
be determined. The obligation to pay damages constitutes a liability and, in accordance
with HKAS 10, Supreme is to recognise this in the financial statements for the 20X4
reporting period. The liability is not a provision as the amount (i.e. HK$5 million) and the
timing of the payment (i.e. 120 days) is now certain. To recognise the liability, Supreme
would record the following journal entry for the end of the 20X4 reporting period (i.e. entry
made on 10/1/20X5 for the year ended on 31 December 20X4):
Debit Credit
HK$ HK$
Compensation expense 5,000,000
Claims payable 5,000,000
Refer to Chapter 18 to gain an understanding of how to identify and account for
contingent liabilities.
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17.2.2 Non-adjusting Events after the Reporting Period
HKAS An entity shall not adjust amounts recognised in its financial statements to reflect non-adjusting
10.10 events after the reporting period.
Given the different accounting treatment, a distinction needs to be drawn between
whether an event constitutes an adjusting or non-adjusting event after the reporting period.
An adjusting event after the reporting period is one that adds clarity to how transactions
or events should be recognised and measured at the end of the reporting period. Though
non-adjusting events may relate to a recognised transaction, event or balance at the end of the
reporting period, they do not relate to the conditions of those transactions, events or balances
as they existed at that time. For example, a building may have existed on 31 December 20X4,
being the end of the 20X4 reporting period, measured at its then depreciated cost. The building
may have burned down on 3 January 20X5, which is after the end of the 20X4 reporting period.
The 20X4 financial statements need to show that the building was held at the end of the
reporting period, measured at its depreciated cost. Non-adjusting events inform entities how to
recognise and measure these transactions at the time of the non-adjusting event, which in this
case, is when the fire occurred on 3 January 20X5. As such, the non-adjusting event should be
recognised in the period in which it occurs, that is, in the 20X5 reporting period.
As demonstrated in Exhibit 17.3, when adjusting and non-adjusting events occur after the
end of reporting period 1 but before reporting period 1’s financial statements are authorised
for issue, the events are recognised in different reporting periods. Adjusting events are
recognised in reporting period 1 by either changing amounts recognised, or recognising
amounts that were not previously recognised, in reporting period 1’s financial statements.
End of reporting period 1 Authorisation date End of reporting period 2
Reporting Period 1 Reporting Period 2
Events occurring during the
period that HKAS 10 applies to
Adjusting events Non-adjusting events
EXHIBIT 17.3 When to recognise adjusting and non-adjusting events
Non-adjusting events are recognised in the reporting period that they occur, that is,
reporting period 2. Though non-adjusting events are recognised in reporting period 2, as
discussed in Section 17.3.3 of this chapter, an entity is required to disclose information about a
non-adjusting event in reporting period 1’s financial statements if it is material.
The following are examples of non-adjusting events after the reporting period (assuming
they occur between the end of the reporting period and the date when the financial statements
are authorised for issue) that do not require an entity to adjust the amounts recognised in its
financial statements:
• A change in the fair value of investments held at the end of the reporting period;
• A declaration of dividends payable to owners;
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Events after the R eporting P eriod
• Entering into a business combination or disposing of a subsidiary;
• Announcing a plan to discontinue an operation;
• The purchase of assets, classification of assets as held for sale in accordance with
HKFRS 5 Non-current Assets Held for Sale and Discontinued Operations, disposal of assets
and expropriation of assets by government (see Chapter 15);
• The destruction of plant by natural disaster;
• An announcement of or commencement of a restructuring;
• A new share issue with no relationship to the past period;
• A change in foreign exchange rates;
• A change in tax rates or tax laws enacted or announced after the reporting period
that effects an entity’s accounting for income taxes per HKAS 12 Income Taxes
(see Chapter 19);
• Entering into commitments or contingent liabilities (e.g. issuing a guarantee); and
HKAS • Commencing litigation arising solely out of events that occurred after the reporting
10.11, 12, 22 period.
Apply and Analyse 3
On 20 January 20X5, Hong Kong experienced a severe electrical storm, causing power
outage in many regions, including the region where Supreme’s Hong Kong plant was
located. Due to the power outage, Supreme’s Hong Kong plant experienced two technical
difficulties. First, the climate-controlled system failed, exposing the ingredients in storage
to excessive humidity and temperature. To comply with food safety standards, Supreme
had to throw out certain ingredients that could no longer be used in the baking process.
The ingredients thrown out were recorded as HK$2 million, with insurance covering
HK$1 million. Second, the automated baking process was out of operation for four days,
as repairs to the plant damaged by the storm were undertaken. The inability to supply the
franchisee bakeries for four days was a breach of the franchisor-franchisee contract. On
20 February 20X5, the franchisees took legal action against Supreme for breach of contract,
claiming HK$1,500,000 damages for lost sales over the four-day period.
Determine whether the electrical storm is an adjusting or non-adjusting event.
Analysis
In accordance with HKAS 10, the occurrence of the electrical storm is a non-adjusting
event because it relates to conditions that arose after the reporting period. The electrical
storm occurred on 20 January 20X5, which is after the end of the reporting period and is
unrelated to circumstances present as at 31 December 20X4. This means the amounts for
unusable inventory, the insurance claim and the legal action of the franchisees should not
be recognised as of that date. Nevertheless, if material, disclosures of the non-adjusting
events would need to have been shown in the notes to the financial statements for the
year ended 31 December 20X4 (refer to Section 17.3.3 of this chapter).
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17.2.3 Going Concern
Due to deterioration in operating results and financial position after the reporting period,
management may determine (between the end of the reporting period and the date when the
financial statements are authorised for issue) that it intends to liquidate the entity, to cease
trading or to acknowledge it has no realistic alternative but to do so.
The deterioration may stem from conditions that existed at the end of the reporting
period (i.e. an adjusting event) or from conditions that arose after the reporting period
(i.e. a non-adjusting event). Irrespective, such a determination by management means that the
going concern assumption is no longer appropriate. In accordance with HKAS 10, if
HKAS management makes this determination an entity shall no longer prepare its financial
10.14 statements on a going concern basis (see Chapter 1).
Therefore, when the going concern assumption is no longer appropriate due to an event
after the reporting period, HKAS 10 requires a fundamental change in the basis of accounting in
HKAS the preparation of a new set of financial statements, rather than making adjustments to
10.15 amounts recognised within the existing set of financial statements.
An entity is to also comply with HKAS 1 Presentation of Financial Statements disclosure
HKAS requirements specific to those instances when financial statements are not prepared on a
10.16(a) going concern basis. Under HKAS 1, when an entity does not prepare financial statements on a
going concern basis, it shall disclose that fact, together with the basis on which it prepared the
HKAS financial statements (e.g. break up or liquidation basis) and the reason why the entity is not
1.25 regarded as a going concern.
Illustrative Example 2
Reliable Cars Private Limited Company (Reliable Cars) is a Hong Kong registered
company that manufactures cars from its manufacturing plant in the Philippines.
While preparing its financial statements for the reporting period ended 30 June 20X9, on
1 August 20X9, a major earthquake occurred in the Philippines that destroyed the entire
plant. The insurance policy of Reliable Cars did not cover a natural disaster of this type.
As the management of Reliable Cars could not raise sufficient capital to recommence
the business, management decided to cease the operations of Reliable Cars. At the time
of the decision to cease operations, the financial statements for the reporting period
ended 30 June 20X9 had not been authorised for issue.
The occurrence of the earthquake is a non-adjusting event, as it relates to conditions
that arose after the reporting period. Following the earthquake, management’s decision
to cease operations meant the going concern assumption was no longer appropriate in
preparation of the financial statements for the reporting period ended 30 June 20X9.
17.2.4 Dividends
HKAS 10 states that if an entity declares dividends to shareholders after the reporting period
but before the financial statements are authorised for issue, the entity shall not recognise
HKAS those dividends as a liability at the end of the reporting period because there is no present
10.12–13 obligation for the entity to pay the dividends at that time. That is, the criteria of a present
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IAS obligation in HKAS 37 Provisions, Contingent Liabilities and Contingent Assets are not satisfied at
10.BC3 reporting period-end.
As the dividends payable are not recognised in the financial statements of the reporting period
that has ended, HKAS 10 regards the declaration of dividends (between the end of the reporting
HKAS period and the date when the financial statements are authorised for issue) as a non-adjusting
10.13 event. Such dividends are, however, disclosed in the notes in accordance with HKAS 1.
Refer to Chapters 18 and 28 to gain an understanding of the recognition requirements
relating to HKAS 37 and the disclosure requirements relating to HKAS 1, respectively.
17.2.4.1 Distribution of Non-cash Assets to Owners – HK(IFRIC) Int-17
There are times when an entity distributes non-cash assets as dividends to its owners or gives
owners the option of receiving non-cash assets or cash as dividends. HK(IFRIC) Int-17
HK(IFRIC) Distribution of Non-cash Assets to Owners provides guidance on, among other issues, when to
Int-17.13 recognise dividends payable arising from such dividend distributions.
Specifically, HK(IFRIC) Int-17 applies to two types of dividend distributions: (1) Distributions
of non-cash assets (e.g. items of property, plant and equipment; businesses as defined in
HKFRS 3 Business Combinations; ownership interests in another entity or disposal groups as
HK(IFRIC) defined in HKFRS 5); and (2) Distributions that give owners a choice a choice of receiving either
Int-17.3 non-cash assets or a cash alternative.
HK(IFRIC) Int-17 states an entity initially recognises a dividend payable on the distributions
mentioned above when the dividend is appropriately authorised and is no longer at the discretion
of the entity. The date on which this occurs depends on whether the declaration of the dividend
(generally by management or the board of directors) is subject to the approval of shareholders:
• If shareholder approval is required, the dividend payable is to be initially recognised on
the date of approval; and
HK(IFRIC)
Int-17.10
IFRIC Int- • If shareholder approval is not required, the dividend payable is to be initially recognised
17.BC19 on the date of declaration.
Though HK(IFRIC) Int-17 specifies different dates on when to first recognise a dividend
payable according to the approval process, there is only one date to consider in determining
whether a non-adjusting event has arisen with respect to dividends: the declaration date.
As such, if an entity declares a dividend between the end of the reporting period and the date
IFRIC Int- when the financial statements are authorised for issue, a non-adjusting event exists under
17.BC20 HKAS 10 irrespective of if and when shareholder approval occurs.
Knowledge Check Questions
Question 2
Farm Supplies Limited (Farm Supplies) is a manufacturer and distributor of farm
equipment to mainland China. On 15 January 20X9, Farm Supplies sold four combine
harvesters to a customer for HK$12 million. On 15 August 20X9, Farm Supplies received
notification the customer was in liquidation and the entire HK$12 million outstanding
became uncollectible. Farm Supplies’ reporting period ended 30 June 20X9 and the
financial statements were authorised for issue on 21 September 20X9.
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Knowledge Check Questions (continued)
Determine whether the liquidation of the customer is an event after the reporting
period for Farm Supplies. If so, explain whether it is an adjusting or non-adjusting event.
Question 3
Investment Horizon Limited (Investment Horizon) is an investment company that invests in
global fixed income, equities and real estate markets. On 1 April 20X7, Investment Horizon
bought HK$20 million worth of shares in Resource Mining Limited (Resource Mining),
a listed mining company in South Africa, in anticipation of Resource Mining receiving
exclusive rights to mine for cobalt in the North-Eastern region. On 15 July 20X7, the
government decided to issue the exclusive rights to a competing mining company, which
resulted in the value of Investment Horizon’s shareholding in Resource Mining declining
by HK$8 million on that day. Investment Horizon’s reporting period-end was 30 June 20X7,
and the financial statements were authorised for issue on 30 September 20X7.
Determine whether the decline in value of Investment Horizon’s shareholding in
Resource Mining is an event after the reporting period for Investment Horizon. If so,
explain whether it is an adjusting or non-adjusting event.
1 7 . 3 DISCLOSURE
HKAS 10 prescribes a number of disclosures to be made by entities in relation to events after the
reporting period. Specifically, HKAS 10 requires an entity to disclose the date of authorisation for
financial statements to be issued, to update disclosures about conditions existing at the end of
the reporting period and to disclose specific information on non-adjusting events should they
occur. Each will be considered in turn.
17.3.1 Date of Authorisation for Issue
HKAS Users must know when the financial statements were authorised for issue because the
10.18 financial statements do not reflect events after this date. As such, HKAS 10 requires an entity to
disclose the date when the financial statements were authorised for issue and who authorised
HKAS their issue. If an entity’s owners or others have the power to amend the financial statements
10.17 after issue, HKAS 10 also requires the entity to disclose that fact.
Illustrative Example 3
Continuing with the facts pertaining to Prime Location in Section 17.1.2, the following is an
example of the information Prime Location would disclose in accordance with HKAS 10:
Note XX: Date of Authorisation for Financial Statements to be Issued
On 8 March 20X4, the management of Prime Location authorised the financial statements
for the reporting period ending 31 December 20X3 be issued to its non-executive
supervisory board for approval.
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Events after the R eporting P eriod
17.3.2 Updating Disclosure about Conditions at the End of
the Reporting Period
As discussed in Section 17.2, an adjusting event is when an entity receives information on
conditions that existed at the end of the reporting period, which requires an entity to adjust
HKAS
amounts recognised in its financial statements or to recognise items that were not previously
10.3(a), 8, 9 recognised.
Whether the information received requires an entity to change amounts recognised or to
recognise amounts that were not previously recognised in its financial statements (i.e. an
adjusting entry) or does not affect recognised amounts, HKAS 10 requires an entity to update
its disclosures in light of this information. In particular, if an entity receives information after
HKAS the reporting period about conditions that existed at the end of the reporting period, it shall
10.19 update disclosures that relate to those conditions in light of the new information.
Illustrative Example 4
Continuing with the facts pertaining to the personal injury lawsuit against Supreme,
on 31 December 20X4, Supreme was subject to a contingent liability, with information
relating to the contingent liability required to be disclosed in accordance with HKAS 37
Provisions, Contingent Liabilities and Contingent Assets.
Under HKAS 37, Supreme was required to disclose information about the contingent
liability if it is more likely than remote that settlement will be required. In light of the
findings released on 1 February 20X5, it is reasonable for Supreme to conclude that
settlement was more likely than remote. As a contingent liability exists, and the possibility
of paying damages is not remote, Supreme is required to disclose the following:
• A brief description of the nature of the contingent liability;
• An estimate of the financial effect of the contingent liability;
• An indication of the uncertainties relating to the amount or timing of any outflow; and
HKAS
37.86 • The possibility of any reimbursement.
Upon both sets of findings being released, a contingent liability no longer exists.
Rather, a liability exists that is to be recognised in Supreme’s 20X4 financial statements.
Due to a shift in the nature of the liability (from a disclosed contingent liability to a
recognised liability), Supreme is required, under HKAS 10, to update its disclosures about
the lawsuit. In particular, because HKAS 37 no longer applies because a contingent liability
no longer exists, the disclosures prepared per HKAS 37 are to be altered to satisfy the
disclosure requirements, if any, of HKAS 1 Presentation of Financial Statements because a
liability now exists.
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17.3.3 Non-adjusting Events after the Reporting Period
Though non-adjusting events do not result in adjustment to an entity’s financial statements,
if they are material, their non-disclosure could reasonably be expected to influence the
decisions that the primary users of general-purpose financial statements make on the basis
of those financial statements. As such, HKAS 10 requires an entity to disclose the following for
each material category of non-adjusting event after the reporting period:
• The nature of the event; and
HKAS
10.21 • An estimate of its financial effect, or a statement that such an estimate cannot be made.
The above disclosure requirements do not, however, apply when the non-adjusting event is
the declaration of dividends payable to owners. Dividends declared are disclosed in accordance
with HKAS 1 and do not need to satisfy a materiality threshold to warrant disclosure. Under
HKAS HKAS 1, an entity is required to disclose the total amount and amount per share of dividends
1.137 declared before the financial statements were authorised for issue.
Refer to Chapter 1 to gain an understanding of the definition of material contained within
and the disclosure requirements relating to HKAS 1.
Illustrative Example 5
Continuing with the analysis of the electrical storm and its impact on Supreme, in
accordance with HKAS 10, Supreme accounts for:
(a) The unusable ingredients; and
(b) The legal claim brought against it by Supreme’s franchisees
in the following manner:
(a) Unusable ingredients:
HKAS Because it is a non-adjusting event, details of the nature of the event and an
10.21 estimate of its financial effect are to be disclosed if it is deemed to be material.
(b) Legal claim:
Though also a non-adjusting event, information Supreme discloses depends on:
(a) whether the legal claim brought against Supreme constitutes a contingent
liability; and (b) whether the possibility of Supreme being required to pay damages
is remote or not.
If a contingent liability does not exist or if the possibility of Supreme paying damages is
remote, the disclosure requirements of HKAS 37 do not apply. Instead, Supreme would
disclose details of the non-adjusting event in accordance with HKAS 10 (i.e. details of the
HKAS nature of the event and an estimate of its financial effect are to be disclosed if it is deemed
10.21 to be material).
If a contingent liability exists, and the possibility of paying damages is not remote,
Supreme is required to disclose the information specified in Illustrative Example 4.
Presuming discarding the non-usable ingredients is material and the lawsuit gives rise to a
possible obligation to pay damages that is not remote (i.e. a contingent liability exists), the
note disclosure relating to the electrical storm may look as follows:
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Illustrative Example 5 (continued)
Note XX: Events Occurring after the End of the Reporting Period
On 20 January 20X5, an electrical storm caused a power outage in Supreme’s Hong Kong
plant, causing ingredients stored on site to fail food safety standards regarding climate
control. As a result, ingredients worth HK$2 million were discarded. Insurance coverage
amounts to HK$1 million.
Due to the electrical storm, damage to the plant meant Supreme was unable to provide
franchisees with goods while it was being repaired. On 20 February 20X5, franchisee
bakeries lodged a lawsuit against Supreme and is seeking damages for lost profits totalling
HK$1,500,000. At this early stage, it was uncertain whether any amount of damages
would be payable. If liable, no amounts would be reimbursed by insurers as liability would
indicate a breach of contract.
Knowledge Check Questions
Question 4
Titan Limited (Titan) is a global distributor of health care products whose reporting period
ends December 31 20X4. Management authorises the 20X4 financial statements for issue
on 20 March 20X5. Identify which of the following is a non-adjusting event that is required
to be disclosed in Titan’s financial statements for the period ended 31 December 20X4.
A On 10 January 20X5, Titan received invoices from creditors totalling HK$20,000 for the
provision of payroll services for the quarter ended 31 December 20X4.
B On 21 January 20X5, it was discovered the accounting department overstated sales
revenue by HK$750,000 for the reporting period ended 31 December 20X4.
C Titan has recently established a distribution centre in Thailand, and on 28 February 20X5,
the foreign exchange rate between Hong Kong and Thai Baht changed from HK$1 = 4.20
Baht to HK$1 = 4.21 Baht.
D Titan acquires 100 percent ownership of a competitor on 15 March 20X5, which will
increase Titan’s market share by 20 percent.
Question 5
The reporting period of Portal Limited (Portal) ends 31 December 20X1. Prior to the financial
statements being authorised for issue on 28 March 20X2, the following events occur:
(a) On 1 February 20X2, two million ordinary shares worth HK$8 each were issued by
Portal following a public share offer. This share issue more than doubles Portal’s
number of ordinary shares outstanding; and
(b) On 25 February 20X2, Portal declared a final dividend of HK$1.20 per share to all
shareholders holding shares prior to 1 February 20X2. There were 1,500,000 shares
outstanding prior to 1 February 20X2.
In accordance with HKAS 10, determine how Portal should account for each event in its
financial statements for the period ended 31 December 20X1.
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1 7 . 4 APPLICATION OF HKAS 10
Below is a decision tree (Exhibit 17.4) for you to follow in the application of HKAS 10:
Does an event occur that falls between
NO The event is not an event after the
the end of the reporting period and the
reporting period and is beyond
date the financial statements are
the scope of HKAS 10
authorised for issue?
YES
Does the event indicate an entity is no YES Financial statements are not to be
longer a going concern? prepared on a going concern basis
NO
Does the event provide evidence of NO Is the event a declaration of dividends
conditions that existed at the end
by an entity to its owners?
of the reporting period?
YES
NO YES
An entity is to account for the event by
Disclose in the notes
adjusting amounts recognised in its
the total amount, and
financial statements, or recognising
Is the event material? amount per share, of
items not previously recognised, as
dividends declared in
well as updating disclosures in light
accordance with HKAS 1
of the event
YES NO
Disclose in the notes
the nature of the event No disclosures about
and an estimate of its the event required
financial effect
EXHIBIT 17.4 How to apply HKAS 10
Key Learning Point
It is necessary to determine whether the event after the reporting period provides
evidence of conditions that existed at the end of the reporting period or not. This
establishes whether the event is an adjusting or non-adjusting event, each of which has
different accounting implications under HKAS 10.
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Events after the R eporting P eriod
SUMMARY
• HKAS 10 sets out how to account for events after the reporting period.
• HKAS 10 defines events after the reporting period as those that occur between the end of the
reporting period and the date when the financial statements are authorised for issue.
• The date when the financial statements are authorised for issue is dependent on an entity’s
authorisation process, but the date must be disclosed by an entity in the notes to account
along with who gave authorisation for the financial statements to be issued.
• HKAS 10 categorises the events after reporting period into adjusting entries and non-
adjusting entries.
• Adjusting events are those that provide evidence of conditions that existed at the end of
the reporting period. If an adjusting event occurs, under HKAS 10 an entity is to update
its financial statements by adjusting amounts recognised in its financial statements or by
recognising items that were not previously recognised to reflect the adjusting event.
• Non-adjusting events indicate conditions that arose after the reporting period. If a
non-adjusting event occurs, an entity is not required to adjust amounts recognised in its
financial statements to reflect the non-adjusting event.
• If an event after the reporting period (whether adjusting or non-adjusting) indicates an entity
is no longer able to operate as a going concern, the entity must not prepare its financial
statement on a going concern basis and must to disclose this fact under HKAS 1.
• The declaration of dividends by an entity after the reporting period is a non-adjusting event
because no obligation to pay exists at the end of the previous reporting period. An entity
recognises a liability for a dividend payable when it is declared or, if shareholder approval is
required, on the date of approval. Under HKAS 1, an entity is, however, required to disclose
in the notes (of the financial statements relating to the previous period) the total amount and
per share amount of dividends declared.
• An entity is to update disclosures in the notes to account for new information on conditions
that existed at the end of the reporting period.
• Other than the declaration of dividends, if a non-adjusting event is material, an entity is to
disclose in the notes (of the financial statements relating to the previous period) the nature of
the event and an estimate of its financial effect.
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MIND MAP
SCOPE OF HKAS 10 DATE OF AUTHORISATION FOR ISSUE
Applies to ‘events after the reporting period’ Will vary according to an entity's
• Those events that occur between the end authorisation process
of the reporting period and the date when • If financial statements are subject to
the financial statements are authorised shareholder approval after being issued,
for issue authorisation date is the same as issue date
• If financial statements are required to be
TYPES OF EVENTS AFTER THE issued to a supervisory board, authorisation
REPORTING PERIOD date is when management authorises
Those that provide evidence of conditions their issue to the board
that existed at the end of the reporting Must disclose the date of authorisation
period for issue and who gave that authorisation
• Adjusting events after the reporting period
EVENTS AFTER THE GOING CONCERN BASIS
Those that are indicative of conditions
that arose after the reporting period REPORTING PERIOD If an event after the reporting period
• Non-adjusting events after the indicates an entity is no longer
reporting period a going concern
• Financial statements are not to be
EVIDENCE OF CONDITIONS THAT EXISTED prepared on a going concern basis
AT THE END OF THE REPORTING PERIOD • Must disclose that the financial statements
Recognition and measurement are not prepared on a going concern
• Update financial statements by adjusting basis per HKAS 1
amounts recognised in the financial
DISCLOSURE
statements, recognising item that were
not previously recognised in the financial For dividends declared after the reporting
statements, to reflect the adjusting entry period, the total amount, and amount per
Disclosure share, of dividends declared per HKAS 1
• Update disclosures about conditions that For other ‘material’ non-adjusting events,
existed at the end of the reporting period the nature of the event and an estimate
in light of new information received after of its financial effect
the reporting period For immaterial non-adjusting events, no
disclosures are required
Answers to Knowledge Check Questions
Question 1
Answer A is incorrect. Though the end of the reporting period is 31 December 20X8, on
15 February 20X9, the financial statements are in draft form only and are not ready to be
authorised for issue.
Answer B is incorrect. The end of the reporting period is 31 December 20X8. However, in
HKAS accordance with HKAS 10, the public announcement of selected financial information
10.7 (in this case on 1 March 20X9) does not constitute financial statement authorisation.
Answer C is correct. The end of the reporting period is 31 December 20X8, and the date of
authorisation is 2 March 20X9 because this is the date the board of directors authorises
the financial statements for issue.
Answer D is incorrect. Yes, the end of the reporting period is 31 December 20X8 but the
HKAS date of authorisation is not when the shareholders approve the financial statements
10.5 (in this case on 31 May 20X9).
Question 2
In accordance with HKAS 10, Farm Supplies’ receipt of a liquidator’s notice is an event after
the reporting period. An event after the reporting period has occurred as it took place on
HKAS 15 August 20X9, which is between the end of the reporting period (30 June 20X9) and the
10.3 date when the financial statements are authorised for issue (21 September 20X9).
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Events after the R eporting P eriod
The event provides evidence of conditions that existed at the end of the reporting
period and, as such, constitutes an adjusting event. Though Farm Supplies did not become
aware of the customer’s inability to repay the debt until after the end of the reporting
period, the sale occurred during the reporting period and the debt was in existence at
reporting period-end. As such, the liquidator’s notice provided additional information to
Farm Supplies on the status of the HK$12 million at the end of the reporting period. In
HKAS accordance with HKAS 10, Farm Supplies must adjust its financial statements for the period
10.8 ended 30 June 20X9 for the debt becomes uncollectible with the following journal entry:
Debit Credit
HK$ HK$
Loss allowance for expected credit losses 12,000,000
Trade receivables 12,000,000
Question 3
The decline in value of Investment Horizon’s shareholding in Resource Mining is an event
after the reporting period because the decline in value took place on 15 July 20X7, which is
HKAS between the end of the reporting period (30 June 20X7) and the date when the financial
10.3 statements are authorised for issue (30 September 20X7).
The event provides evidence of circumstances that have arisen after the end of the
reporting period and, as such, constitutes a non-adjusting event. In this instance, the
circumstances that arose after the end of the reporting period was the government’s
decision to issue mining rights to a competing mining company. The decline in value in
HKAS Investment Horizon’s shareholding does not relate to the condition of the shareholding at
10.10–11 the end of the reporting period and, as such, in a non-adjusting event.
Question 4
Answer A is incorrect. The receipt of invoices from creditors for services performed during
the 20X4 reporting period is an adjusting event because it provides evidence of conditions
that existed at the end of the reporting period, that is, it provided evidence of amounts
owing to creditors as at 31 December 20X4.
Answer B is incorrect. The detection of an error in revenue recognised for the reporting
period ended 31 December 20X4 is an adjusting event because it provides evidence of
conditions that existed at the end of the reporting period, that is, it provided evidence of
the correct amount of revenue earned for the 20X4 reporting period.
Answer C is incorrect. The exchange rate fluctuation on 28 February 20X5 constitutes a
non-adjusting event because it relates to new conditions created after reporting
period-end. However, it can be argued that the fluctuation is not material given it was small
in magnitude. HKAS 10 requires disclosure of exchange rate fluctuations after the
HKAS reporting period only when they are ‘abnormally large’. As it is not material, disclosure of
10.22(g) this event by Titan is not required.
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Answer D is correct. The acquisition of the competitor occurred on 15 March 20X5, which is
after the end of the 20X4 reporting period. Despite negotiations potentially occurring
during the 20X4 reporting period, the acquisition reflects circumstances that have
subsequently arisen and, as such, is a non-adjusting event. In addition, because the
acquisition will increase Titan’s market share by 20 percent, the acquisition is probably a
HKAS material non-adjusting event, thereby requiring Titan to disclose the nature of the event
10.3, 22(a) and an estimate of its financial effect in its 20X4 financial statements.
Question 5
The issue of ordinary shares by Portal on 1 February 20X2 is a non-adjusting event because
it relates to conditions that have arisen subsequent to reporting period-end, that is, the
creation and issuance of new shares after the end of the reporting period. In addition,
given the share issue more than doubles Portal’s number of shares outstanding, the share
issue is probably material. As such, Portal should account for the share issue by disclosing
the nature of the event (i.e. a share issue) and an estimate of its financial effect (i.e. an
HKAS increase in share capital by HK$16 million) in the financial statements for the reporting
10.21, 22(f) period ended 31 December 20X1. Also, in accordance with HKAS 33 Earnings per Share,
Portal is to disclose a description of the share issue as it would have significantly changed
HKAS the number of ordinary shares outstanding at the end of the 20X1 reporting period if it had
33.70(d) occurred during that period. Though differing disclosure requirements exist relating to the
share issue under HKAS 10 and HKAS 33, there is overlap between the information
required under HKAS 10 (‘the nature of the event’) and HKAS 33 (‘a description of the
transaction’).
The declaration of dividends on 25 February 20X2 is a non-adjusting event. The
declaration of dividends is indicative of conditions that arose subsequent to the
HKAS reporting period because there is no present obligation for the entity to pay the
10.12–13 dividends at the end of the reporting period. Dividends declared are disclosed in
accordance with HKAS 1 and do not need to satisfy the HKAS 10 materiality threshold to
warrant disclosure. As such, in accordance with HKAS 1, Portal is required to disclose the
total amount (1,500,000 shares × HK$1.20 per share = HK$1,800,000) and amount per
HKAS share (HK$1.20) of dividends declared in the financial statements for the reporting period
1.137 ended 31 December 20X1.
Overall, the note disclosure relating to the above non-adjusting events may look
as follows:
Note XX: Events Occurring after the End of the Reporting Period
On 1 February 20X2, there was a public share issue of two million ordinary shares at
HK$8 per share, raising HK$16 million in share capital.
On 25 February 20X2, dividends of HK$1.20 per share were declared, totalling
HK$1,800,000 dividends payable.
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Events after the R eporting P eriod
EXAM PRACTICE
QUESTION 1
EcoTour is an ecotourism business that operates a fleet of boats for sightseeing tours of
dolphins, whales and coral reefs in the waters surrounding Hong Kong. The following events
took place after the end of the 31 December 20X2 reporting period but before the financial
statements were authorised for issue on 22 March 20X3:
On 28 January 20X3, EcoTour took delivery of a glass-bottomed boat for its coral reef
tours. The boat was purchased on 15 December 20X2 for HK$1,250,000 and was in transit at
the end of the reporting period. The boat was paid for in advance on the date of purchase.
The recognition of the boat (at cost) and the payment have already been captured in
EcoTour’s financial statements for the year ended 31 December 20X2. Upon delivery, an
inspection of the boat revealed cracks in the glass and the boat was returned on 5 February
20X3. A full refund was received by EcoTour on 12 February 20X3.
On 1 February 20X3, one of EcoTour’s dolphin watching boats sank during a severe
electrical storm. Though the boat was insured, EcoTour experienced lost profits of
HK$300,000 because EcoTour needed until 1 March 20X3 to find a suitable replacement.
On 15 March 20X3, EcoTour received a letter notifying it that it was successful in
receiving a government grant of HK$5 million to start up a conservation project to protect
the pink dolphin and to increase population numbers through breeding in captivity. The
decision of the grant recipients was at the sole discretion of the government. EcoTour
applied for the government grant on 15 November 20X2.
Required:
Advise EcoTours on how the above events should be accounted for in its financial
statements for the reporting period ended 31 December 20X2.
QUESTION 2
Flamp is a manufacturer and retailer of children’s toys and sporting equipment for all age
groups. Flamp’s current reporting period ended 31 December 20X4. The following events
took place before the 20X4 financial statements were authorised for issue on 15 March 20X5:
On 30 December 20X4, FunGames 8 was released, which is the latest version of the
FunGames home video game console. The release of FunGames 8 meant demand for
its predecessor (FunGames 7) was going to decline dramatically. In an effort to sell its
remaining stock of FunGames 7, the management of Flamp decided to reduce the selling
price of FunGames 7 to 50% below cost. The decision was made on 3 January 20X5 and was
effective immediately. Inventories of FunGames 7 on hand at 31 December 20X4 (at cost)
were HK$250,000.
On 16 February 20X5, a lawsuit was lodged against Flamp by the family of a child who
choked on a building block. The lawsuit alleges negligence against Flamp, with the family
claiming HK$10 million in damages. The sale of the toy occurred on 1 December 20X4.
A date has not been set for the court proceedings to begin. Flamp has product liability
insurance, which protects it against claims of personal injury caused by Flamp’s products.
Under the insurance policy, the product liability limit that is payable by the insurer in the
event of a successful claim being lodged against Flamp is HK$3 million. On 3 March 20X5,
the Commissioner of Customs and Excise fined Flamp HK$500,000 for a breach of safety
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FINANCIAL REPORTING
standards in relation to the production of a new product line of tricycles. Production began
on 3 January 20X5. Flamp lodged a notice of appeal on 16 March 20X5.
Required:
Advise Flamp on how the preceding events should be accounted for in its financial
statements for the reporting period ended 31 December 20X4.
ANSWERS TO EXAM PRACTICE
QUESTION 1
Return of boat
In accordance with HKAS 10, the receipt and subsequent return of the glass-bottomed boat
provides evidence of conditions that existed at the end of the reporting period and, as such,
constitutes an adjusting event. Though EcoTours did not become aware of the fault in the
boat after the end of the reporting period, the purchase of, and payment for, the boat
occurred during the reporting period, with the asset existing at reporting period-end.
As such, the discovery of the fault upon receipt of the boat provided information to EcoTours
HKAS
on the status of the asset as at the end of the reporting period. As such, it is an
10.3 adjusting event.
Because it is an adjusting event, EcoTours must adjust amounts recognised in its
statement of financial position for the return of the boat and the subsequent cash refund. To
do this, EcoTours would record the following journal entry at the end of the 20X2 reporting
period (i.e. on entry made on 12 February 20X3 for the year ended 31 December 20X2):
Debit Credit
HK$ HK$
Cash 1,250,000
Boat 1,250,000
Occurrence of electrical storm
The electrical storm relates to conditions that arose after the end of the reporting period
and, as such, constitutes a non-adjusting event. The electrical storm occurred on 1 February
HKAS
20X3, which is after the end of the reporting period and is unrelated to circumstances
10.3 present as at 31 December 20X2. As such, it is a non-adjusting event.
HKAS
Because it is a non-adjusting event, details of the nature of the event and an estimate of
10.21 its financial effect are to be disclosed if it is deemed to be material.
Receipt of government grant
The receipt of the government grant provides evidence of circumstances that have arisen
after the end of the reporting period and, as such, constitutes a non-adjusting event. Though
the application occurred during the reporting period ended 31 December 20X2, receipt of
the grant was subject to the government’s discretion. As at 31 December 20X2, the decision
HKAS
was yet to be reached and, as such, could not relate to conditions that existed at reporting
10.3 period-end. As such, it is a non-adjusting event.
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Events after the R eporting P eriod
HKAS
As a non-adjusting event, details of its nature and an estimate of its financial effect are to
10.21 be disclosed if the event is considered to be material.
Presuming the occurrence of the electrical storm and the receipt of the government
grant are deemed to be material, the note disclosure relating to the electrical storm and the
government grant may look as follows:
Note XX: Events Occurring after the End of the Reporting Period
On 1 February 20X3, an electrical storm occurred that resulted in a sightseeing boat
sinking. Lost profits of HK$300,000 resulted.
On 15 March 20X3, EcoTours received a government grant of HK$5 million to
commence a conservation project that will increase the population of pink dolphins
through a captive breeding program.
QUESTION 2
Release of FunGames 8
In accordance with HKAS 10, the reduced selling price of FunGames 7 provides evidence of
conditions that existed at the end of the reporting period and constitutes an adjusting event.
The release of FunGames 8 occurred before the end of the 20X4 reporting period (i.e. on
30 December 20X4) and, as a result, the amount recognised as inventory on hand as at
31 December 20X4 is overstated. The release of FunGames 8 and the subsequent decision,
on 3 January 20X5, to reduce the selling price of FunGames 7 provided information to Flamp
HKAS 10.3, on the value of inventory at the end of the 20X4 reporting period. As such, an adjusting
9(b)(ii) event exists.
Because it is an adjusting event, Flamp must adjust amounts recognised in its statement
of financial position for the inventory write-down to net realisable value. To do this, Flamp
would record the following journal entry for the end of the 20X4 reporting period (i.e. entry
made on 3/1/20X5 for the year ended on 31 December 20X4):
Debit Credit
HK$ HK$
Loss on inventory write down 125,000
Finished goods inventory 125,000
Initiation of lawsuit
The lawsuit provides evidence of conditions that existed at the end of the reporting period
and constitutes an adjusting entry. As the lawsuit relates to an event that occurred during
the reporting period, namely, the sale on 1 December 20X4, the lawsuit provides information
HKAS to Flamp on a possible obligation to pay damages (all or part of which may be covered by
10.3 product liability insurance) that exists as at the end of the reporting period.
Despite being an adjusting event, Flamp does not adjust amounts recognised in its
statement of financial position for the possible obligation to pay damages arising from the
lawsuit. A present obligation does not exist, as the matter is yet to come before the courts.
Because no present obligation exists, a liability is not recognised as at 31 December 20X4.
Instead, a contingent liability exists and is to be disclosed in Flamp’s financial statements for
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FINANCIAL REPORTING
the 20X4 reporting period (presuming the possibility of paying damages is not remote).
Specifically, Flamp is required to disclose an estimate of the financial effect of the contingent
HKAS liability, an indication of the uncertainties relating to the amount or timing of any outflow
37.86 and the possibility of any reimbursement.
Imposition of fine
The imposition of a fine provides evidence of circumstances that have arisen after the end of
the reporting period and, as such, constitutes a non-adjusting event. The fine arose as a
HKAS consequence of an event that occurred after the end of the reporting period, namely, the
10.3 production of a faulty tricycle that commenced on 3 January 20X5.
HKAS As a non-adjusting event, details of its nature and an estimate of its financial effect are to
10.21 be disclosed if the event is considered to be material.
Presuming the possibility of paying damages in relation to the lawsuit is not remote and
presuming the imposition of the fine is deemed to be material, the note disclosure relating
to the lawsuit and fine may look as follows:
Note XX: Events Occurring after the End of the Reporting Period
On 16 February 20X5, a customer lodged a lawsuit seeking damages of HK$10 million.
As the matter is yet to come before the court, whether any damages will be payable is
uncertain. Any amount payable will be reimbursed by insurers up to HK$3 million.
On 3 March 20X5, a fine of HK$500,000 was received due to the production of a new
product line of tricycles allegedly not complying with safety standards. Flamp has lodged a
notice to appeal the fine.
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18
Provisions, Contingent
Liabilities and
Contingent Assets
CHAPTER TOPIC LIST
18.1 Overview 18.3.2 Risk and Uncertainties
18.1.1 Scope 18.3.3 Present Value
18.1.2 Terminology 18.3.4 Future Events
18.1.3 Distinction Between Provisions 18.3.5 Expected Disposal of Assets
and Other Liabilities 18.4 Reimbursements
18.1.4 Relationship Between
Provisions and Contingent
18.5 Changes in Provisions
Liabilities 18.6 Application of the Recognition
18.2 Recognition and Measurement Rules
18.2.1 P resent Obligation as a 18.6.1 Future Operating Losses
Result of a Past Event 18.6.2 Onerous Contracts
18.2.2 Probable Outflow of 18.6.3 Restructuring
Resources Embodying 18.6.4 Reinstatement of Premises,
Economic Benefits Decommissioning and
18.2.3 Reliable Estimate of the Restoration Activities
Obligation 18.7 Disclosure
18.2.4 Contingent Liabilities 18.7.1 Provisions
18.2.5 Contingent Assets 18.7.2 Contingent Liabilities
18.3 Measurement 18.7.3 Contingent Assets
18.3.1 Best Estimate 18.8 Current Developments
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FINANCIAL REPORTING
LEARNING OUTCOMES
PRINCIPAL LO3: EVALUATE AND ADVISE ON APPROPRIATE ACCOUNTING POLICIES TO ACCOUNT
FOR COMPLEX BUSINESS TRANSACTIONS
LO3.10: A
ccount for, evaluate and advise on business transactions in accordance with Hong Kong
Financial Reporting Standards as they relate to: Provisions, contingent liabilities and
contingent assets
3.10.01 Explain provisions, contingent liabilities and contingent assets
3.10.02 Evaluate the differences between trade payables, accruals and provisions
3.10.03 Apply the criteria for recognition of provisions to specific circumstances
3.10.04 Apply the appropriate accounting treatment for onerous contracts
3.10.05 Apply the appropriate accounting treatment for contingent assets and liabilities
3.10.06 Account for decommissioning, restoration and similar liabilities and their changes
3.10.07 Prepare and appraise disclosure in respect of provisions, contingent liabilities and
contingent assets
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P rovisions , C ontingent L iabilities and Contingent Assets
OPENING CASE
SPARKLE
S parkle Limited (Sparkle) is a retail company offering a range of cleaning products, including
brooms, mops and disinfectants. It predominantly operates an online retail business,
with an online shopping platform offered on the company’s website. As part of its marketing
campaign, Sparkle also promotes its products through regular segments on Hong Kong’s
television shopping channel. In addition, Sparkle has two physical retail stores located in
Hong Kong.
Sparkle’s most recent product innovation is the ‘Swivel 360’, which is a broom with
a moveable head to enable sweeping in hard-to-reach places. As part of its product
launch, Sparkle has extensively advertised that it will offer a money-back guarantee to any
dissatisfied customer.
Though the management of Sparkle is optimistic about the success of the ‘Swivel 360’, it
has concerns about the ongoing viability of its vacuum cleaner division. Currently, Sparkle only
sells manually operated vacuum cleaners. Due to the arrival of the robot vacuum cleaner, sales
for Sparkle’s manually operated vacuum cleaners have declined dramatically. As a result, the
management of Sparkle has recommended to the board of directors the closing down of the
vacuum cleaner division.
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FINANCIAL REPORTING
OVERVIEW
Within business, assets and liabilities are characterised by uncertainty. Such uncertainty may
relate to the item’s amount when future inflows or outflows of economic benefits will occur or
whether future inflows or outflows of economic benefits will occur. The presence and degree of
such uncertainty influence the accounting treatment of these assets and liabilities, with entities
being required to account for, and disclose information in relation to, uncertain assets and
liabilities in a way that is distinct from how they account for, and disclose information about,
other, more certain, assets and liabilities.
More specifically, an entity may be subject to a liability of uncertain amount or timing.
A liability of this nature is different to some other liabilities, such as trade payables because,
though the entity may have determined that it has an obligation, uncertainty exists about the
amount and timing of outflows of economic benefits necessary to settle the obligation. Such a
liability is called a provision.
An entity may also establish that it is possible that a liability exists but the item in question
does not meet the criteria for recognition in the financial statements. This can arise as a result
of uncertainty about whether an obligation exists, insufficient probability that an outflow of
economic benefits would be required to settle the obligation, or an inability to reliably measure
the amount of the obligation. Such a liability constitutes a contingent liability. Similarly, an
entity may have a potential entitlement to receive an economic benefit in the future, such as
cash, but the entity is uncertain about whether it will receive any economic benefit. As distinct
from many of an entity’s other assets, such as trade receivables or cash holdings, there is
significant uncertainty about whether any economic benefits will be received. In such cases, a
‘possible’ asset exists and is referred to as a contingent asset.
This chapter discusses the nature of provisions, contingent liabilities and contingent assets,
how an entity is to account for each, and the types of information to disclose in relation to
each. Initially, you will gain an understanding of how to evaluate provisions and distinguish
them from contingent liabilities and other liabilities of an entity. Subsequently, you will gain
an understanding of the recognition and measurement criteria pertaining to provisions and
apply the criteria to a range of specific circumstances an entity may face including warranty
commitments, the expectation of future operating losses, the fulfilment of onerous contracts,
plans to restructure business operations, and the obligation to undertake decommissioning
and restoration activities. You will also gain an understanding of how to account for contingent
assets and contingent liabilities. Finally, you will be able to prepare and appraise note
disclosures pertaining to provisions, contingent liabilities and contingent assets.
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P rovisions , C ontingent L iabilities and Contingent Assets
1 8 . 1 OVERVIEW
This chapter outlines the characteristics of provisions, contingent liabilities and contingent
assets and, upon identifying their existence, how an entity is to account for and the
information to be disclosed in relation to each respective item. Such issues are governed by
HKAS 37 Provisions, Contingent Liabilities and Contingent Assets. The objective of HKAS 37 is to:
• Ensure that appropriate recognition criteria and measurement bases are applied to
provisions, contingent liabilities and contingent assets; and
HKAS 37 • That sufficient information is disclosed in the notes to the financial statements to
Obj enable users to understand their nature, timing and amount.
In this section, you will gain an understanding of the scope of HKAS 37 and be introduced to
terminology that will build your understanding of what are provisions, contingent liabilities and
contingent asset. You will also develop an understanding of what distinguishes provisions from
other liabilities and contingent liabilities.
18.1.1 Scope
HKAS 37 is to be applied by all entities in the accounting and disclosure for provisions,
contingent liabilities and contingent assets except for:
• Those resulting from executory contracts unless the contract is onerous; and
HKAS
37.1 • Those covered by another Standard.
HKAS Executory contracts are contracts under which neither party has performed any of its
37.3 obligations or both parties have partially performed their obligations to an equal extent. As
each party has offsetting contractual rights and obligations, an executory contract is not
recognised in either party’s statement of financial position. If, however, the executory contract
becomes onerous to one party, that party is to recognise a provision in accordance with
HKAS 37. Onerous contracts are discussed in Section 18.6.2 of this chapter.
Standards other than HKAS 37 may address a specific type of provision, contingent
liability or contingent asset. If so, an entity is to apply that standard instead of HKAS 37. In
particular, HKAS 37 does not apply to provisions, contingent liabilities or contingent assets
resulting from:
• Financial instruments (including guarantees) within the scope of HKFRS 9 Financial
Instruments (see Chapter 12);
• Income taxes (see HKAS 12 Income Taxes in Chapter 19);
• Leases, except for any lease that becomes onerous before the commencement date of
the lease, or for short-term leases and leases for which the underlying asset is of low
value and that has become onerous (see HKFRS 16 Leases in Chapter 9), in which case
HKAS 37 applies;
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• Employee benefits (see HKAS 19 Employee Benefits in Chapter 23);
• Insurance contracts (with policyholders) within the scope of HKFRS 17 Insurance
Contracts (see Chapter 26);
• Contingent consideration of an acquirer in a business combination (see HKFRS 3
Business Combinations in Chapter 29); and
• Revenue from contracts with customers (see HKFRS 15 Revenue from Contracts with
HKAS 37.2, 5
HKFRS Customers in Chapter 5) unless the contract has become onerous, in which case HKAS
16.App D 37 applies.
18.1.2 Terminology
HKAS 37 defines a liability as ‘a present obligation of the entity arising from past events, the
HKAS settlement of which is expected to result in an outflow from the entity of resources embodying
37.10 economic benefits’.
HKAS An entity may be subject to different types of liabilities, one of which is a provision. HKAS 37
37.10 defines a provision as ‘a liability of uncertain timing or amount’. In addition, an entity may also
have established that a contingent liability exists. HKAS 37 defines a contingent liability as:
• 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
• A present obligation that arises from past events but is not recognised because:
°° An outflow of resources embodying economic benefits will probably not be
required to settle the obligation; or
HKAS
37.10
°° The amount of the obligation cannot be measured with sufficient reliability.
In addition to holding assets, an entity may also have a contingent asset, which HKAS 37
defines as ‘a possible asset that arises from past events and whose existence will be confirmed
HKAS only by the occurrence or non-occurrence of one or more uncertain future events not wholly
37.10 within the control of the entity’. This definition is slightly different to that described in the
Conceptual Framework. In most cases, the difference should not result in a different
reporting outcome.
18.1.3 Distinction Between Provisions and Other Liabilities
Exhibit 18.1 compares provisions to other common classes of liabilities.
In Exhibit 18.1, the level of uncertainty (in terms of timing and amount) for the trade
payable for inventory and the accrual for electricity is relatively low. In contrast, the timing and
amount for a warranty payment is generally higher and, as such, are accounted for separately
than other classes of liabilities.
Key Learning Point
It is essential to determine whether an entity has incurred a liability of uncertain amount or
timing so as to establish whether HKAS 37 is applicable.
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P rovisions , C ontingent L iabilities and Contingent Assets
$100 ?
$ Invo
ice $
Trade payables for goods or Accruals for goods or services Provisions for future payments
services that have been received that have been received or to other parties in respect of
or supplied and have been supplied, but have not been past events where the amount
invoiced or formally agreed invoiced or formally agreed and/or timing of the outflow is
with the supplier with the supplier uncertain
Example: trade payable for Example: accrual for electricity Example: settlement of warranty
inventory purchase on credit where invoice not yet received claims on manufactured goods
UNCERTAINTY LOW MEDIUM HIGH
EXHIBIT 18.1 Distinguishing provisions from other liabilities
18.1.4 Relationship Between Provisions and Contingent Liabilities
Exhibit 18.2 outlines the two alternative ways in which provisions and contingent liabilities are
distinguishable:
ALTERNATIVE 1
PROVISION CONTINGENT LIABILITY
Obligation type: Present obligation Obligation type: Possible obligation
ALTERNATIVE 2
PROVISION CONTINGENT LIABILITY
Obligation type: Present obligation Obligation type: Present obligation
Criteria for recognition (i.e. probable Criteria for recognition (i.e. probable
occurrence and reliable occurrence and reliable
measurement): Both satisfied measurement): Either not satisfied
EXHIBIT 18.2 Two alternative ways provisions and contingent
liabilities are distinguishable
Key Learning Point
In the first instance of Exhibit 18.2, it is necessary to assess whether an entity is subject to
a present or possible obligation to determine whether a provision or contingent liability
exists. If the entity is subject to a present obligation, a provision exists unless the general
recognition criteria are not satisfied, in which case a contingent liability exists.
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Knowledge Check Question
Question 1
Identify which one of the following is within the scope of HKAS 37.
A A construction company has a five-year contractual obligation to pay its Chief Executive
Officer an annual bonus of 1% of company profits.
B A travel insurance company has a contractual obligation to compensate its policyholders
in the event of their belongings being stolen while travelling.
C A retail company has a contractual obligation to repair any defective products it has sold
to customers that are returned within 60 days of sale.
D A cleaning services company has a contractual obligation to provide cleaning services to
a chain of hotels for three years.
1 8 . 2 RECOGNITION
Having examined the definition of a provision, contingent liability and contingent asset, it is
now appropriate to detail the HKAS 37 recognition requirements pertaining to each item. In
particular, it is important to consider whether a provision, contingent liability or contingent
asset is to be recognised in an entity’s statement of financial position and, if so, under what
conditions.
The recognition criteria for provisions are summarised in Exhibit 18.3.
Does the entity have a present
obligation as a result of
a past event (See Section 18.2.1)? NO
YES
It is probable that an outflow No provision
(See Section 18.2.2) of resources recognised in
embodying economic benefits statement of
will be required to settle the NO financial
obligation? position
YES
Can a reliable estimation (See
Section 18.2.3) be made of the
amount of the obligation? NO
YES
Recognise provision in
statement of financial position
EXHIBIT 18.3 Recognition criteria for provisions
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HKAS
An entity does not recognise a contingent liability or contingent asset in its statement of
37.27, 31 financial position.
The following section elaborates on the HKAS 37 recognition requirements pertaining to
provisions, contingent liabilities and contingent assets.
18.2.1 Present Obligation as a Result of a Past Event
The first condition that must be satisfied to recognise a provision in the statement of financial
position is that an entity has a present obligation as a result of a past event. In almost all
instances, whether a past event has given rise to a present obligation will be clear. In rare
instances, for example, in a lawsuit, whether a present obligation exists may be unclear. In
these rare instances, an entity is to consider all available evidence and make a judgement as
to whether a present obligation exists. This judgement is to occur at the end of the reporting
period, and if it is deemed:
• More likely than not that a present obligation exists, the first condition to recognise a
provision is satisfied; or
HKAS • More likely than not that no present obligation exists, a contingent liability exists as the
37.15–16 entity has a possible obligation as a result of a past event.
18.2.1.1 Legal and Constructive Obligations
A present obligation may be a legal or a constructive obligation. Exhibit 18.4 summarises the
key characteristics of legal and constructive obligations and provides an example of each.
Present obligations
Constructive
Legal
Constructive obligations arise when:
Legal obligations arise through the existence
of one of the following: • There is an established pattern of past
practice or published policies that has
indicated to other parties that the entity will
accept certain responsibilities; AND
• The entity has created a valid expectation on
Legislation or other the part of other parties that it will discharge
A contractual agreement
operation of law those responsibilities.
A warranty agreement A legislative requirement A retail store that has a published policy
EXAMPLES issued to customers at for a company to clean up of offering refunds to customers where
the time of sale of goods contaminated land there is no legal requirement to do so
EXHIBIT 18.4 Types of present obligation: legal and constructive
18.2.1.2 Past Event
HKAS A past event that creates a present obligation (whether a legal or constructive obligation) is
37.10, 17 called an obligating event if an entity has no realistic alternative to settling that obligation.
No realistic alternative to settlement exists:
• Where the settlement of the obligation can be enforced by law; or
HKAS • In the case of a constructive obligation, where the event creates valid expectations in
37.17 other parties that the entity will discharge the obligation.
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By definition, a past event that creates a present obligation is an obligating event because a
legal or constructive obligation presumes the entity has no alternative but to settle the obligation.
A past event that, at the time of the event, does not eliminate an entity’s ability to avoid
settlement is not an obligating event. It can, however, become an obligating event once there is
no realistic alternative but to settle. For example, a management or board decision only
becomes an obligating event once it has been communicated to other parties in a sufficiently
specific manner to raise a valid expectation that the entity will discharge the responsibilities
HKAS stemming from its decision. Prior to its communication, the decision is internal that may be
37.20 altered or reversed (i.e. realistic alternatives other than settlement still exist).
The intention to incur expenditure in the future is not a past event because the entity can
HKAS avoid the future expenditure at its own discretion (e.g. by deciding not to undertake the
37.19 expenditure). In this instance, no provision is recognised.
Illustrative Example 1
Oil Exploration Ltd (Oil Exploration) drills for oil in the Nile delta. On 21 September 20X0, a
ruptured pipeline caused the spillage of millions of litres of oil into the delta before the leak
was stopped. At the time of the spillage, there was no legal requirement in the jurisdiction in
which Oil Exploration was drilling to rectify the contamination caused. It was Oil Exploration’s
business custom to not rectify contamination unless there was a legal responsibility to do
so. Mindful of the public’s perception of Oil Exploration as an environmentally responsible
corporate citizen, on 30 December 20X0, the CEO of Oil Exploration issued a public pledge to
clean up the oil spillage and any future oil spills that is causes.
At the time of the oil spill, neither a legal nor a constructive obligation exists for Oil
Exploration to clean the oil spill. Oil Exploration has no legal obligation because no law
requires contamination to be rectified. There is no constructive obligation because Oil
Exploration’s pattern of past practice is to not clean up oil spills unless legally required to
do so. As such, at the time of its occurrence, the oil spill is not an obligating event.
However, upon making a public announcement that it would rectify the contamination
caused by the oil spill a constructive obligation exists. Oil Exploration has altered its business
practice and indicated to the public that, as an environmentally responsible corporate citizen,
it will accept responsibility for the oil spill and clean it. Upon making this announcement, the
public validly expects Oil Exploration will clean the oil spill, and no reasonable alternative
exists for Oil Exploration other than to rectify the environmental damage caused.
Therefore, the past event, being the oil spill, becomes an obligating event on
30 December 20X0.
18.2.2 Probable Outflow of Resources Embodying Economic Benefits
Once it is established that a present obligation exists, the second condition must be satisfied to
recognise a provision in the statement of financial position: an outflow of resources embodying
economic benefits will probably be required to settle the present obligation. An outflow of
HKAS resources is regarded as probable if it is more likely than not to occur. That is, the probability it
37.23 will occur is greater than the probability it will not.
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HKAS 37 clarifies that, in situations where similar obligations exist (e.g. product warranties), an
HKAS
entity is to assess the probability an outflow will be required by considering the population as a
37.24 whole, rather than as one single item. For example, for each individual product sold under
warranty, an entity has an obligation to fulfil the warranty conditions. The likelihood the entity will
be required to repair or replace a particular faulty product, as part of the warranty conditions, may
be small. However, some products sold under warranty will probably be faulty and require repair or
replacement. As such, when considering individual warranty obligations collectively, some outflow
of resources will probably be required by the entity, thereby satisfying this recognition criterion.
18.2.3 Reliable Estimate of the Obligation
A distinguishing feature between a provision and certain other liabilities is the uncertainty
about the amount of the future expenditure required in settlement (see Section 18.1.3). Such
uncertainty, however, does not preclude a provision from being recognised in an entity’s
financial statements. Provided a reliable estimate can be made of the obligation amount, the
third condition to recognise a provision is satisfied.
Except in rare cases, an entity will be able to determine a range of possible outcomes and,
therefore, can make an estimate of the amount of the obligation sufficiently reliable to use in
recognising a provision. In those rare cases where no reliable estimate can be made, this
HKAS recognition criteria is not satisfied and, consequently, a contingent liability exists
37.25-26 (see Section 18.1.4).
Apply and Analyse 1
As part of Sparkle’s product launch of the ‘Swivel 360’, it is offering a money-back guarantee
to any dissatisfied customer. Sparkle has offered a similar refund policy in the past on other
products and, thus, is able to estimate the number of refunds it will need to provide.
Determine whether Sparkle should recognise a provision in its statement of financial
position in relation to its refund policy.
Analysis
Applying HKAS 37, Sparkle must recognise a provision if there is: (a) a present obligation
as a result of a past event; and (b) probably an outflow of resources embodying economic
benefits required to settle the obligation; and (c) a reliable estimate of the amount of the
obligation can be made. The application of HKAS 37 to Sparkle’s refund policy is as follows:
Criteria Application
(a) The sale of the ‘Swivel 360’ is the past obligating event. Though Sparkle is under no legal
obligation to offer a full refund to any dissatisfied customer, a constructive obligation
arises at the point of sale. As Sparkle has extensively advertised its money-back
guarantee to prospective customers, it has created a valid expectation on the part of
those customers that it will refund purchases of the ‘Swivel 360’.
(b) Considering individual refund obligations as a collective, some customers will likely
return their ‘Swivel 360’ purchases and seek their money back. As such, an outflow of
resources (i.e. cash) will probably be required to settle the constructive obligation.
(c) Based upon past experience, Sparkle will be able to make a reliable estimate of the cost
of its refund policy.
In conclusion, Sparkle should recognise a provision for its refund policy in its statement
of financial position.
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Key Learning Point
If it is established that an obligating event has occurred, a present obligation (constructive
or legal) is deemed to exist. If an outflow of economic resources will probably be required
to settle the obligation and, though a degree of uncertainty exists, the amount required to
settle the obligation can be reliably estimated, and a provision must be recognised.
18.2.4 Contingent Liabilities
A contingent liability can possibly become a provision upon the occurrence of a future event.
For example, an entity may establish a present obligation has arisen because of a past event
but has determined an outflow of resources embodying economic benefits will probably not be
required to settle the obligation. Based upon these determinations and the definition of a
contingent liability considered earlier, a contingent liability exists which, under HKAS 37, must
not be recognised in the entity’s statement of financial position. If, however, an outflow of
resources will probably be required (and presuming a reliable estimate of the uncertain
amount of the obligation can be made), a contingent liability no longer exists and a provision
must be recognised from the time when the change in probability occurs. An entity is,
HKAS therefore, required to continually assess the circumstances relating to contingent liabilities to
37.30 identify whether any changes to those circumstances impact the accounting treatment.
Illustrative Example 2
On 1 July 20X6, after cleaning the kitchen floor with his recently-purchased ‘Swivel
360’, an elderly gentleman slipped and suffered personal injury. Upon recovering, the
customer commenced legal action against Sparkle, seeking damages of HK$1,000,000
for pain and suffering. Sparkle’s lawyers have advised that it is unlikely it will be found
liable because the fall can be attributed to several factors, including the customer’s age
and the cleaning detergent used. Such legal advice was provided on 15 December 20X6
and continued to be the lawyers’ advice up to the release of Sparkle’s 20X6 financial
statements.
As of 31 December 20X6, Sparkle is subject to a contingent liability. In rare instances,
such as a lawsuit, Sparkle is required to make a judgement whether a present obligation
exists based upon all available evidence. On the basis of the evidence available, Sparkle
may conclude that a present obligation does not exist. Such a conclusion can be reached
according to the legal advice Sparkle has obtained, which attributes the fall to factors other
than the ‘Swivel 360’. As such, Sparkle is subject to a possible obligation whose occurrence
is confirmed by the occurrence of an uncertain future event (namely, the court deciding in
favour of the customer, and awarding damages), which constitutes a contingent liability.
HKAS
Exhibit 18.5 shows a decision tree to follow in determining the existence of a provision or
37.App B contingent liability in accordance with HKAS 37.
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Start
Present obligation
No Possible No
as a result of an
obligating event? obligation?
Yes Yes
Possible No Yes
Remote?
outflow?
Yes No
Reliable No (rare)
estimate?
Yes
Disclose contingent
Provide Do nothing
liability
EXHIBIT 18.5 Determining the existence of a provision
or contingent liability per HKAS 37
18.2.5 Contingent Assets
HKAS An entity is not to recognise a contingent asset, as defined in HKAS 37, in its financial
37.31 statements.
A contingent asset is defined as a ‘possible’ asset whose existence will only be confirmed by
uncertain future events not wholly within the entity’s control. Because of the uncertainty
relating to the expected inflow of future economic benefits, recognition of a contingent asset
may result in the recognition of income that may never be realised. However, if the inflow of
HKAS economic benefits is nearly certain, the asset is no longer contingent and should be recognised
37.32, 33 in the statement of financial position.
HKAS An entity is required to continually assess contingent assets to ensure the accounting
37.35 treatment is updated to reflect any developments.
Illustrative Example 3
Building Bridges Ltd (Building Bridges) specialises in the construction of pedestrian
footbridges throughout Asia. The materials used to construct each footbridge vary
according to specifications provided by the consulting engineer. In 20X5, Building Bridges
constructed a footbridge in mainland China based upon the designs provided by Cutting
Edge Designs Ltd (Cutting Edge). On 1 March 20X6, the footbridge collapsed resulting
in 15 people sustaining injuries. On 1 June 20X6, the injured pedestrians commenced
litigation against Building Bridges. In response, Building Bridges commenced litigation
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Illustrative Example 3 (continued)
against and is requesting compensation from Cutting Edge for negligence, claiming that
the bridge materials used were consistent with the design specifications provided by
Cutting Edge. Cutting Edge is disputing the counterclaim, arguing that the collapse of the
bridge was attributable to Building Bridges using inferior materials. The court’s decision
on Building Bridges’ claim was pending when Building Bridge’s 20X6 financial statements
were authorised for issue.
In accordance with HKAS 37, Building Bridges has a contingent asset. A possible asset
exists (the potential right to receive damages from Cutting Edge) arising from a past event
(the collapse of the bridge) whose existence will be confirmed by the occurrence of an
uncertain event not within Building Bridges’ control (the court finding in favour of Building
Bridges). As the likelihood of receiving damages is less than nearly certain, there is no asset
recognised in Building Bridges’ statement of financial position. If, however, the likelihood of
HKAS receiving damages is probable, Building Bridges is required to disclose information about
37.34 the contingent asset in the notes to its 20X6 financial statements.
Refer to Section 18.7.3 of this chapter for a discussion of the HKAS 37 disclosure
requirements pertaining to contingent assets.
Knowledge Check Questions
Question 2
GlamRock Ltd (GlamRock) is a talent agency that represents musicians, and television and
movie actors. On 1 July 20X3, GlamRock dismissed a senior employee for gross misconduct
after an online industry magazine published disparaging comments about GlamRock’s
most prominent client, which the magazine attributed to the senior employee. GlamRock
immediately dismissed the employee upon becoming aware of the comments. The
employee did not receive a termination payment because GlamRock asserts the employee
breached its employment contract upon making the comments.
On 1 December 20X4, the employee commenced legal action against GlamRock,
denying making the comments. The employee is seeking damages of HK$10 million for
GlamRock’s breach of an implied duty of trust and confidence owed to the employee.
GlamRock has sought legal advice, with GlamRock’s lawyers advising that GlamRock will
probably not be found liable.
GlamRock’s reporting period end is 31 December.
Advise GlamRock on how it should account for the legal action taken against it as of
31 December 20X4.
Question 3
Continuing with the above facts, on 1 November 20X5, the court found in favour of the
employee but delayed a decision on damages until 1 March 20X6. While the employee is
seeking HK$10 million damages, the court is able to award damages of a different amount.
Advise GlamRock on how it should account for the legal action taken against it as of
31 December 20X5.
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1 8 . 3 MEASUREMENT
The purpose of this section is to discuss the considerations an entity faces when trying to
determine a reliable estimate of the amount of the obligation.
18.3.1 Best Estimate
In accordance with HKAS 37, the amount to be recognised as a provision is the entity’s ‘best
HKAS estimate’ of the expenditure required to settle the present obligation at the end of the
37.36 reporting period.
How an entity calculates the ‘best estimate’ depends upon the nature of the provision.
Where the provision involves a number of similar obligations (e.g. product warranties), the
provision is estimated by considering the population as a whole. That is, the entity weights all
possible outcomes by their associated probabilities to derive an ‘expected value’ of the
collective obligation. If, however, each possible outcome is as likely to occur as the other is
HKAS (i.e. the probability of each possible outcome occurring is equal), the midpoint of the range of
37.39 possible outcomes is used as the expected value of the collective obligation.
An entity’s management identifies the range of possible outcomes, the associated
HKAS probabilities and the financial consequences of them occurring based upon its judgement,
37.38 experience and, in some cases, independent expert reports.
Illustrative Example 4
Continuing the Apply and Analyse 1’s scenario in Section 18.2.3, Sparkle must reliably
estimate the amount to be recognised. The retail price of the ‘Swivel 360’ is HK$200. For
the 20X7 reporting period, Sparkle sold 500,000 ‘Swivel 360’s. Based upon experience,
the management of Sparkle estimate that, for 20X7, there is:
• An 80% likelihood that no customers will seek a full refund;
• A 15% likelihood that 10,000 customers will seek a full refund; and
• A 5% likelihood that 20,000 customers will seek a full refund.
Sparkle measures its warranty provision as the expected value of the cost of providing
full refunds by weighting all possible outcomes by their differing associated probabilities,
which equals:
(80% HK$200 0 customers) (15% HK$200 10, 000 customers)
(5% HK$200 20, 000 customers) HK$500, 000
HKAS Where the provision involves a single obligation, the individual most likely outcome may be
37.40 the best estimate of the amount to be recognised.
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Once again, an entity’s management identifies the range of possible outcomes, the
HKAS associated probabilities and the financial consequences of them occurring based upon their
37.38 judgement, experience and, in some cases, independent expert reports.
Apply and Analyse 2
Continuing Illustrative Example 2 in Section 18.2.4, on 1 May 20X7, the court found in
favour of the customer but has yet to reach a decision on damages. The management
of Sparkle believes the full amount of damages requested by the customer will likely be
awarded to him (HK$1 million) although a higher or lower amount may be awarded.
Explain how Sparkle is to account for the legal action against it.
Analysis
Sparkle would now recognise a provision based upon the following analysis:
Criteria Application
Present obligation as a The customer falling after using the ‘Swivel 360’ is the obligating
result of a past event event. Due to the court decision, Sparkle has a present (legal)
obligation to compensate the customer for the personal injuries
he sustained due to using the ‘Swivel 360’. The possible obligation
that existed in Illustrative Example 2 in Section 18.2.4 has become a
present obligation following the court’s decision.
Probable outflow of An outflow of resources will probably be required to settle the legal
resources embodying obligation because Sparkle has no realistic alternative but to pay
economic benefits to settle the damages.
the obligation
Reliable estimate can be As the most likely outcome is that Sparkle will be required to
made of the amount of the pay HK$1 million damages, Sparkle will recognise an amount of
obligation HK$1 million as a provision. Though there are possible outcomes
other than the repayment of HK$1 million, these possible outcomes
are higher and lower in amount than the most likely outcome
amount. As these alternate amounts are neither ‘mostly higher’ nor
‘mostly lower’ than the most likely outcome amount, they are not
included in calculating the best estimate of the provision.
HKAS The best estimate of a provision is to be determined before tax because the tax
37.41 consequences of the provision are dealt with under HKAS 12 Income Taxes (see Chapter 19).
18.3.2 Risk and Uncertainties
As evident from the preceding discussion, an entity faces uncertainty when measuring a
provision. Such uncertainty extends to which of the possible outcomes will ultimately occur in
the future. HKAS 37 regards the variability of possible outcomes as risk and requires an entity
HKAS to take into account the risks and uncertainties of possible outcomes occurring in reaching the
37.42 best estimate of a provision. In doing so, HKAS 37 requires an entity to make a risk adjustment
HKAS that increases the amount at which a provision is measured but not to the extent that the
37.43 provision becomes excessive and overstated.
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18.3.3 Present Value
The time value of money is a concept that a sum of money now differs in value to an identical
sum of money in the future. In the context of provisions, the time value of money establishes
that cash outflows required to settle an obligation at the end of the current reporting period
HKAS are more onerous to an entity than cash outflows of the same amount required to settle the
37.46 obligation in future reporting periods.
Where the effect of the time value of money is material, HKAS 37 requires an entity to discount
HKAS provisions to their present value. That is, the recognised amount of a provision is to be the present
37.45 value of the expenditures expected to be required to settle the obligation. HKAS 37 does not offer
guidance to the entity in determining when the effect of the time value of money is material.
An entity is to discount a provision to present value using a pre-tax discount rate that
reflects current market assessments of:
• the time value of money; and
HKAS
37.47 • the risks specific to the liability.
Recall from the previous section that an entity is to factor in the risks and uncertainties of
possible outcomes occurring when determining the best estimate of a provision. Where future
HKAS cash flow estimates used to derive the best estimate of a provision have been adjusted for risk,
37.47 the discount rate should not reflect this risk; otherwise, the risk will be counted twice.
In practical terms, an entity may have difficulty identifying the risks specific to each
provision and quantifying these risks for inclusion in a provision-specific discount rate. Instead,
an entity could, in deriving the best estimate of a provision, adjust future cash flow estimates
for risk and then use a risk-free rate for a liability with the same term (e.g. government bonds)
to discount the provision to present value.
Where an entity discounts a provision to present value, any subsequent increase in the
HKAS provision due to the passage of time is recognised as a borrowing cost in the entity’s statement
37.60 of profit or loss.
Illustrative Example 5
Cars Galore Ltd (Cars Galore) is a motor vehicle dealership that sells a range of sports and
prestige motor vehicles from its showroom in Central, Hong Kong. Cars Galore offers each
customer a five-year warranty whereby Cars Galore will repair any mechanical defects at
no charge to the customer if detected by customers within the five years of purchase.
As of 31 December 20X1, Cars Galore estimates the future cash outflows required to
meet its warranty obligations in each of the five years as follows:
Year Estimated future
cash outflows
HK$
1 900,000
2 750,000
3 480,000
4 290,000
5 120,000
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Illustrative Example 5 (continued)
Cars Galore’s future cash outflow estimates are based upon the expenditure (i.e. the
cost of labour and materials) expected to be incurred to fulfil one warranty claim and the
number of claims expected to be made in each of the five years. Each of the estimated
annual claims has been adjusted for the risk that a range of possible outcomes might
occur. The pre-tax, risk-free rate on five-year government bonds is 5%.
Assuming the effect of the time value of money is material, under HKAS 37, Cars Galore
must recognise a provision at an amount that equals the present value of the expected
expenditure required to settle the warranty obligations as a collective. Given risk has been
factored into the expected future cash outflows, no further adjustment for risk is made to
the discount rate. As such, Cars Galore discounts expected future cash outflows to present
value using the 5% pre-tax, risk-free rate on government bonds with the same term
(i.e. five years).
Based upon this information the recognised amount of the provision is HK$2,284,664,
calculated as follows:
Year Estimated future Discount rate Present value of
cash outflows future cash outflows
HK$ HK$
1 900,000 1/1.05 857,143
2 750,000 1/1.052
680,272
3 480,000 1/1.053 414,642
4 290,000 1/1.054
238,584
5 120,000 1/1.055
94,023
Present value 2,284,664
18.3.4 Future Events
The amount required to settle an entity’s present obligation might be affected by the occurrence
HKAS of future events. If this is the case, the entity is to reflect this in estimate of the amount
37.48 recognised as a provision when there is sufficient objective evidence the future events will occur.
For example, potential new legislation that expands the geographic region over which an entity
is legally required to clean up contamination it has caused is to be taken into consideration
when determining the best estimate of the amount of the provision when sufficient objective
HKAS evidence exists that the legislation is nearly certain to be enacted. HKAS 37 states that, in many
37.50 cases, sufficient objective evidence will not exist until the new legislation is enacted.
Illustrative Example 6
Urban Ltd (Urban) has a contractual obligation to clean a site it is currently operating at
the end of the site’s useful life. Under HKAS 37, Urban is required to recognise a provision
at an amount that reflects Urban’s best estimate of the expenditure required to settle the
obligation. Urban believes the cost of cleaning the site will decline due to technological
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Illustrative Example 6 (continued)
advancements. To factor such cost reductions into its best estimate, Urban is required to
have sufficient objective evidence as to the technology that will be available at the time of
HKAS the clean-up and how the advanced technology will reduce the costliness of the clean-up.
37.49 This may include seeking the support of technically qualified, objective observers.
18.3.5 Expected Disposal of Assets
Gains from the expected disposal of assets are not be taken into account when measuring the
amount of a provision even if the expected disposal is closely linked to the event that gives rise
HKAS to the provision. Rather, an entity is to recognise gains on the expected disposal of assets at the
37.51, 52 time specified by the standard or standards that deal with the relevant asset or assets. In
essence, HKAS 37 prevents an entity from offsetting gains from the expected disposal of assets
against the provision to derive a ‘net’ amount recognised as a provision. The entity is to account
for the provision and the gains separately.
Knowledge Check Questions
Question 4
Scoot Around Ltd (Scoot Around) sells a range of motor scooters. The terms of each sales
contract oblige Scoot Around to cover the cost of repairs of any manufacturing defects on
scooters returned by customers within the first nine months of purchase. Scoot Around
estimates that if minor defects exist in all scooters sold during the current reporting period
(20X6), repair costs of HK$2 million would result. If major defects exist in all scooters sold
during 20X6, estimated repair costs would be HK$6 million. Based upon experience, the
management of Scoot Around estimate that, for 20X6, 70% of scooters sold will have no
defects, 20% of scooters sold will have minor defects and 10% of scooters sold will have
major defects. Assume the time value of money is not material.
Determine whether Scoot Around must recognise a provision in relation to its warranty
commitments and, if so, what amount is to be recognised as a provision.
Question 5
Continuing with the facts presented in Questions 2 and 3, on 1 March 20X6, the court
awarded damages of HK$5 million to the employee, with HK$1 million payable by
GlamRock on 1 January 20X7 and with HK$2 million payable on 1 January 20X8 and 20X9,
respectively.
The court’s decision to stagger damages payments is to avoid GlamRock experiencing
financial hardship because it has recently issued corporate bonds to raise money
to expand its business into the sub-continent. The corporate bond rate offered by
Glamrock is 4%.
Glamrock, however, has decided to appeal against the severity of the damages. The
court of appeals is scheduled to hear the case in early 20X7.
Calculate the amount recognised as a provision as at 31 December 20X6, assuming the
time value of money is material.
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1 8 . 4 REIMBURSEMENTS
There may be instances where an entity will recover some or all of the expenditure incurred
to settle a provision from another party. For example, an entity may have legal liability
insurance, whereby an insurer will cover the cost (in part or in full) of compensation payable
by the entity if found liable for losses sustained by a wrongfully terminated employee. The
HKAS other party may reimburse the entity for the amount paid or pay the amounts directly to the
37.55 affected employee. For the purposes of HKAS 37, either approach is referred to as a
reimbursement.
Where some or all of the expenditure required to settle a provision is expected to be
reimbursed by another party, an entity must recognise the reimbursement as a separate
HKAS asset when it is nearly certain that reimbursement will be received if the entity settles the
37.53 provision.
HKAS The amount recognised for the reimbursement is not, however, to exceed the amount of
37.53 the provision. If an entity does recognise the reimbursement as an asset, HKAS 37 permits
the entity to present, in the statement of profit or loss and other comprehensive income, the
HKAS expense relating the provision net of the recognised amount for the reimbursement
37.54 asset.
How an entity is to account for a provision and any associated reimbursement asset reflects
that, generally, the entity remains liable for the entire amount owing to settle the provision
(i.e. the amount it would be required to pay in full should the third party fail to pay for whatever
reason). As such, the provision and the expected reimbursement are to be accounted for
HKAS separately, with the expected reimbursement recognised only when the entity is nearly certain
37.56 that reimbursement will be received.
Illustrative Example 7
Continuing with Illustrative Example 5 in the previous section, Cars Galore has a
contractual agreement with the manufacturers of the sports and prestige motor vehicles
whereby the manufacturers will reimburse Cars Galore for the cost of materials used by
Cars Galore to repair mechanical defects during the warranty period. As of 31 December
20X1, Cars Galore has invoiced the manufacturers for the cost of materials at an amount
of HK$1.145 million. The manufacturers have agreed, in writing, to reimburse Cars
Galore that amount by 31 March 20X2.
Under HKAS 37, Cars Galore recognises a provision for the full amount of the liability
which, based upon the previous Illustrative Example, is HK$2,284,664. Because Cars
Galore is almost certain part of the expenditure required to settle the provision will be
reimbursed, Cars Galore recognises a separate asset equal to the amount for which it will
be reimbursed (HK$1,145,000).
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Illustrative Example 7 (continued)
HKAS 37 permits Cars Galore to present the expense relating to the warranty provision
netted off, which is reflected in the following journal entry:
Debit Credit
HK$ HK$
Warranty costs asset 1,145,000
Warranty costs 1,139,664
Warranty provision 2,284,664
1 8 . 5 CHANGES IN PROVISIONS
At the end of each reporting period, an entity is to review the best estimate and adjust the
HKAS provision’s carrying amount if the current best estimate deviates from last period’s best
37.59 estimate.
As part of this annual review, an entity may determine that an outflow of resources will
HKAS probably not be required to settle the obligation. If this is the case, the provision is to be
37.59 reversed.
Where a provision is discounted to present value, the carrying amount of the provision will
HKAS increase each period to reflect the passage of time. The increase in the provision’s carrying
37.60 amount is recognised as a borrowing cost.
Illustrative Example 8
Extending the Analyse and Apply 1 scenario in Section 18.2.3 and Illustrative Example 4 in
Section 18.3.1, due to the success of its advertising campaign, Sparkle continues its offer
of a money-back guarantee to any dissatisfied customer who purchases a ‘Swivel 360’
during the 20X8 reporting period. The retail price of the ‘Swivel 360’ remains HK$200,
and Sparkle sold 600,000 ‘Swivel 360’s during the 20X8 reporting period. Based upon
experience from 20X7, during which 2,000 ‘Swivel 360’s were returned by customers
and who were given a full refund, the management of Sparkle estimate for 20X8 is the
following:
• A 75% likelihood that no customers will seek a full refund;
• A 20% likelihood that 15,000 customers will seek a full refund; and
• A 5% likelihood that 22,500 customers will seek a full refund.
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Illustrative Example 8 (continued)
Sparkle measures its warranty provision as the expected value of the cost of providing
full refunds by weighting all possible outcomes by their differing associated probabilities,
which equals:
(75% HK$200 0 customer ) (20% HK$200 15, 000 customers)
(5% HK$200 22, 500 customers) HK$825, 000
At the time of estimating the 20X8 warranty provision, 3,000 ‘Swivel 360’s were
returned by customers for which a full refund was given.
The best estimate of the warranty provision for 20X7 was HK$500,000. However, the
warranty provision was reduced in 20X7 by the amount of HK$400,000 (HK$200 × 2,000)
due to the full refunds given by Sparkle to its customers. This is reflected in the following
journal entry:
Debit Credit
HK$ HK$
Warranty provision 400,000
Cash 400,000
Based upon the preceding information, the carrying amount of the warranty provision
at the end of the 20X7 reporting period is HK$100,000.
At the time of estimating the provision in 20X8, Sparkle had provided a further
HK$600,000 in full refunds (HK$200 × 3,000) as reflected in the following journal entry:
Debit Credit
HK$ HK$
Warranty provision 600,000
Cash 600,000
At this point, the carrying amount of the warranty provision has a debit balance of
HK$500,000. That is, Sparkle has underprovided for the cost of refunding customers upon
return of the ‘Swivel 360’. This, however, is before Sparkle has recorded its estimate of the
warranty provision for 20X8.
Sparkle must increase the carrying amount of the provision by HK$825,000 to reflect
the current (i.e. 20X8) best estimate with the following journal entry:
Debit Credit
HK$ HK$
Warranty costs 825,000
Warranty provision 825,000
Following this entry, the carrying amount of the warranty provision at the end of the
20X8 reporting period is HK$325,000.
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Knowledge Check Questions
Question 6
Farm Supplies Limited (Farm Supplies) is a manufacturer and distributor of organic farming
equipment in Hong Kong. It enters into an agreement with a local farmer to manufacture
a customised fertiliser distributor and applicator. The sale took place on 31 December
20X0. As part of the agreement, Farm Supplies offers a three-year warranty, during which
time it will cover the cost of repairing any mechanical defects. From prior experience,
Farm Supplies expects the hydraulics will need replacing in three years at an estimated
cost of HK$95,000. Farm Supplies has factored risk into its estimate of the expected future
cash outflow on the warranty claim. The pre-tax, risk-free rate on three-year government
bonds is 4%.
Farm Supplies has a 31 December reporting period end date.
Assuming the effect of the time value of money is material, how will Farm Supplies
account for the provision in each of the three years? Prepare the relevant journal entries as
part of your answer.
Question 7
Due to technological advancements, the cost of replacing the hydraulics has fallen.
As a result, on 31 December 20X2, Farm Supplies re-estimates the cost of replacing the
hydraulics to be HK$80,000.
Assuming all other facts remain unchanged, explain how Farm Supplies will account
for the provision following its re-estimation. Prepare the relevant journal entries as part of
your answer.
1 8 . 6 APPLICATION OF THE RECOGNITION
AND MEASUREMENT RULES
An entity is required to apply the general recognition criteria to establish whether a provision
exists and, if so, the general measurement rules to determine the amount at which it is
recognised. There is, however, additional guidance offered to entities in the application of
the general recognition and measurement requirements of HKAS 37 to three specific areas:
(1) future operating losses; (2) onerous contracts; and (3) obligations pertaining to restructuring
activities. Each will be considered in turn.
18.6.1 Future Operating Losses
An entity may expect to incur operating losses in the future. Though a future operating loss will
HKAS result in the sacrifice of future economic benefits, HKAS 37 states a provision must not be
37.63 recognised for future operating losses. A provision must not be recognised because an
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FINANCIAL REPORTING
obligating event has not occurred. No present obligation exists because the entity’s
management has realistic alternatives available to avoid incurring a future operating loss
(e.g. restructuring business operations).
18.6.2 Onerous Contracts
HKAS 37 defines an onerous contract as a contract in which the unavoidable costs of meeting
HKAS the obligations under the contract exceed the economic benefits expected to be received
37.10 under it.
A contract may:
• Be onerous at its inception because an entity may agree to an initial onerous contract
with a new customer to demonstrate the quality of its product or service. For example,
a manufacturer may enter into a supply contract with a new customer to increase
market share knowing the supply price will be below costs of production; or
• Become onerous over the contract’s duration. For example, an increase in costs of
production may result in the cost of production now exceeding a supply price that,
under the terms of the supply contract, is fixed.
HKAS If an entity is party to an onerous contract, the present obligation under the contract is to
37.66 be recognised and measured as a provision by the entity. A present obligation exists because
the entity has a contractual (legal) obligation to fulfil the contract.
An entity may have alternative courses of action available to exit from an onerous contract,
including:
• Fulfilling the contractual payments over the agreed upon term of the contract; or
• Exiting the contract early at a penalty.
HKAS 37.68, When recognising a provision in respect to an onerous contract, HKAS 37 states the amount
37.68A to be recognised is the least net cost of exiting from the contract. The least net cost of exiting
the contract is the lower of the:
• cost of fulfilling the contract (refer to Chapter 5) and;
• any compensation or penalties from failing to fulfil the contract.
The cost of fulfilling a contract consists of:
• the incremental costs of fulfilling that contract (e.g. direct labour and materials); and
• an allocation of other costs that directly relate to fulfilling contracts (e.g. an allocation
of depreciation on property, plant and equipment used in fulfilling that and other
contracts).
Whichever of the above alternative courses of action is least costly to the entity, the
provision is recognised and measured at this amount.
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Apply and Analyse 3
On 1 October 20X5, Entertainer Ltd (Entertainer) enters into a supply agreement with a
major customer with the following terms:
• Entertainer is to supply 500 marquees (made to the customer’s specifications) at a
price of HK$5,000 per marquee;
• If Entertainer cannot deliver the marquees on time and under the terms of the
contract, it must pay the customer a penalty of HK$1.5 million; and
• The delivery date is 30 April 20X6.
Prior to commencing manufacturing of the marquees, the production manager
determines that, due to a recent increase in the cost of shade cloth required to
manufacture the marquees in accordance with the customer’s specifications, direct labour
and materials costs, and the allocation of depreciation charges on the machinery used
to manufacture the customised marquees, equal HK$5,500 per marquee. Production
is suspended pending a decision on whether or not to go ahead with the order.
On 31 December 20X5, no inventory had been recognised by Entertainer.
How should Entertainer account for the supply agreement as of 31 December 20X5?
Analysis
As of 31 December 20X5, Entertainer is subject to an onerous contract because the costs
of meeting the supply agreement (HK$5,500 × 500 marquees = HK$2.75 million) exceed
the economic benefits now expected to be derived under it (HK$5,000 × 500 marquees =
HK$2.5 million). Under HKAS 37, Entertainer is to recognise a provision, supported by the
following analysis:
Criteria Application
Present obligation as a result of a The signing of the supply contract is the obligating
past event event because entering into the contract created a legal
obligation to comply with the terms of the agreement.
Probable outflow of resources Upon the supply contract being onerous as of
embodying economic benefits to settle 31 December 20X5, an outflow of resources embodying
the obligation economic benefits is probable.
Reliable estimate can be made of the A provision is to be recognised at the least net cost of
amount of the obligation exiting from the supply contract. Entertainer has two
alternative courses of action to exit from the contract:
1. Fulfil the contractual obligations, which will require
Entertainer to produce the marquees at a cost of
HK$2.75 million while deriving economic benefits
of HK$2.5 million, giving rise to a net cost of
HK$250,000; or
2. Fail to fulfil the contractual obligations and incur a
penalty of HK$1.5 million.
Under HKAS 37, Entertainer will recognise a provision as of 31 December 20X5 at an
amount of HK$250,000.
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Key Learning Point
An onerous contract may exist at the beginning of the contract or at any time over the
contract’s duration. As such, an entity is to regularly assess whether and, if so, when the
unavoidable costs of meeting the obligations under the contract exceed the economic
benefits expected to be received under it. Should that occur, a provision is to be
recognised.
18.6.3 Restructuring
An entity may engage in one or more forms of restructuring thoughout its life cycle.
A restructuring is a programme planned and controlled by management and that materially
changes either:
• The scope of a business undertaken by an entity; or
HKAS
37.10 • The manner in which that business is conducted.
The forms of restructuring that fall within this definition include, but are not limited to, the
following:
• The sale or termination of a line of business;
• The closure of business locations in a country or region;
• The relocation of business activities from one country or region to another;
• Changes in management structure (e.g. removing a layer of management); and
HKAS • Fundamental reorganisations that have a material effect on the nature and focus of the
37.70 entity’s operations.
HKAS 37 details how the general recognition criteria apply specifically to restructurings.
Each criterion will be considered in turn.
18.6.3.1 Present Obligation as a Result of a Past Event
Recall, a present obligation may be a constructive or a legal obligation.
Generally, an entity’s management or the board of directors instigates a restructuring.
A constructive obligation to restructure arises only when an entity has:
(a) A detailed formal plan for the restructuring; and
HKAS (b) Raised a valid expectation in those affected that it will carry out the restructuring by
37.72 implementing that plan or announcing its main features to those affected by it.
Exhibit 18.6 outlines the key features of a restructuring plan to consider in determining
whether a constructive obligation exists.
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DOES A SUFFICIENTLY DETAILED FORMAL PLAN EXIST? HAS A VALID EXPECTATION BEEN RAISED?
The plan must identify at least: Entity raises a valid expectation by:
• The business or part of a business concerned; • Starting to implement the restructuring plan
• The principal locations affected; (e.g. dismantling plant or selling assets); or
• The location, function and approximate number of AND • Publicly announcing a plan to restructure in
employees that will be compensated for terminating sufficient detail (i.e. outlining the main features)
their services; that affected parties (e.g. customers, employees
• The expenditures that will be undertaken; and and suppliers) form valid expectations that the
• When the plan will be implemented. restructuring will occur
Entity fails to raise a valid expectation if:
• There is a long delay between the public
announcement and the proposed commencement
date of the restructuring; or
• The entity announces that the restructuring will
occur over an unreasonably long period of time.
EXHIBIT 18.6 Restructuring plan features indicating whether a constructive obligation
exists or not
Where the restructuring is the sale of an operation or line of business, a present obligation
does not arise until the entity has a legal obligation to carry out the restructuring (i.e. a binding
sale agreement has been entered into with a purchaser). Signing the sale agreement is the
obligating event because, prior to this, the entity may be able to change its mind or may be
forced to take another course of action if a purchaser cannot be found. When a sale is only part
HKAS of a restructuring, a constructive obligation can arise for the other parts of the restructuring
37.78, 79 before a binding sale agreement exists.
18.6.3.2 Probable Outflow of Resources Embodying Economic Benefits
Once it is established that a present (legal or constructive) obligation to restructure exists,
there is no reasonable alternative other than to settle the obligation. As such, it is probable
that an outflow of resources embodying economic benefits will be required to implement the
restructuring plan.
18.6.3.3 Reliable Estimate of the Obligation
In determining the best estimate of the expenditure required to implement the restructuring
HKAS
plan, an entity is to include only the direct expenditures arising from the restructuring.
37.72 Exhibit 18.7 outlines the direct expenditure to include in, and exclude from, a restructuring
provision:
HKAS
37.73, 74 INCLUDED IN PROVISION EXCLUDED FROM PROVISION
Those expenditures that are both: The following expenditure:
• Necessarily entailed by the restructuring; and • The cost of retraining or relocating continuing staff;
• Not associated with the ongoing activities of the • Marketing costs;
entity. • The cost of investing in new systems and
distribution networks;
• Future operating losses up to the date of the
planned restructuring, unless they relate to an
onerous contract; and
• Gains on the expected disposal of assets.
EXHIBIT 18.7 The type of expenditure to include in and exclude from a restructuring
provision
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Illustrative Example 9
Upon considering management’s recommendation to close the vacuum cleaner division,
on 1 December 20X8, Sparkle’s board of directors decides to support the closure. As
part of that decision, the board directed management to develop a closure plan. At a
board meeting on 14 December 20X8, the directors unanimously voted in favour of the
proposed plan to close the division. The plan included information on the number of
employees who will receive redundancy payments due to the closure and the estimated
cost Sparkle will incur to close the division (HK$3.5 million), the implementation date of
the plan (1 May 20X9), and the length of time taken to close the division (six weeks).
Upon the board approving the division closure plan, on 15 December 20X8, an
announcement was made to all customers on Sparkle’s website and via email, explaining
the division closure and advising customers to seek an alternate supplier. On the same
day, redundancy notices were sent to all staff within the division.
As of 30 December 20X8, Sparkle had to recognise a restructuring provision based
upon the following analysis:
Criteria Application
HKAS
37.80 Present obligation as a Sparkle has a constructive obligation because:
result of a past event • A formal plan for the restructuring exists that is sufficiently
detailed; and
HKAS
37.80–84
• A valid expectation exists amongst those affected by the closure
that the restructuring will be carried out given Sparkle has
communicated the decision to customers and staff within the
division. The communication of the decision to the employees
and customers is the obligating event, with the constructive
obligation created on that date (15 December 20X8). Given
there is a short delay between the announcement and
commencement of the division closure (4.5 months) and the
closure will take place over six weeks is further support that
valid expectations exist the restructuring will occur.
Probable outflow of As a constructive obligation exists, an outflow of resources
resources embodying embodying economic benefits will probably be required to
economic benefits to settle implement the restructuring plan.
the obligation
Reliable estimate can be The estimated direct expenditures arising from the restructuring are
made of the amount of the HK$3.5 million
obligation
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18.6.4 Reinstatement of Premises, Decommissioning and
Restoration Activities
An entity may alter leasehold premises to meet its operating requirements. For example, a
manufacturer may undertake alterations to a newly leased factory to ensure the factory’s
layout optimises the manufacturer’s production processes. If the lease agreement requires an
HKAS 37.19, entity, at the end of the lease term, to restore the alterations made to the premises, the entity
Example 3A is to recognise a provision for the expected restoration costs.
Illustrative Example 10
Dome Limited (Dome) enters into a lease agreement with a shopping mall operator,
where it agrees to lease a retail store within the shopping mall for a 10-year period.
Upon entering the lease, Dome modifies the store layout to ensure consistency with
Dome’s other retail stores. Under the lease agreement, Dome is required to reinstate the
premises at the end of the lease by restoring all alterations made.
Under HKAS 37, Dome is required to recognise a provision because the general
recognition criteria are satisfied:
Criteria Application
Present obligation as a The making of the alterations creates a legal obligation under the
result of a past event terms of the lease to restore the alterations made to the premises.
Thus, the commencement of the alterations is the obligating event.
Probable outflow of As a legal obligation to reinstate the premises exists, there is no
resources embodying reasonable alternative other than to fulfil that obligation. As such, an
economic benefits to outflow of resources embodying economic benefits will probably be
settle the obligation required to restore the alterations made to the premises.
Reliable estimate can be The recognised amount of the provision is the best estimate of
made of the amount of the eventual costs incurred to restore the alterations made to the
the obligation premises. These costs will be included as part of the cost of the
alterations made.
Under HKFRS 16 Leases, the estimated cost to reinstate the premises is to be included
in the cost of the right-of-use asset when the obligation first arises (see Chapter 9) as
reflected in the following journal entry:
Debit Credit
HK$ HK$
Right-of-use asset XXX
Provision for reinstatement of premises XXX
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When an entity closes all or part of its operations, it may be obliged to restore the site on
which it operated to its original condition. Similarly, when an asset reaches the end of its useful
life, an entity may be obliged to dismantle and remove the asset from its current location. The
obligation to do so may be a constructive or a legal obligation.
Under HKAS 37, an entity is required to recognise a provision for its obligation to undertake
decommissioning and restoration activities, measured at the entity’s best estimate of the
expected costs it will incur to carry out these activities and settle the obligation.
The following discussion focuses on one specific accounting issue faced by an entity that
recognises a provision for decommissioning and restoration costs.
18.6.4.1 HK(IFRIC) Interpretation 1 Changes in Existing Decommissioning, Restoration
and Similar Liabilities
Decommissioning and restoration costs recognised as a provision may also be, per HKAS 16
Property, Plant and Equipment, included in the cost of an item of property, plant and equipment
(see Chapter 7). In particular, HKAS 16 requires the cost of an item of property, plant and
equipment to include the initial estimate of the costs of dismantling and removing an asset
and restoring the site on which it is located. The types of costs that fall within this HKAS 16
requirement correspond to the types of costs recognised as a provision under HKAS 37.
HK(IFRIC) Interpretation 1 Changes in Existing Decommissioning, Restoration and Similar
Liabilities (HK(IFRIC) Int-1) provides guidance on how to account for the effect of changes in the
measurement of existing decommissioning, restoration and similar liabilities, where the costs
to engage in such activities are both:
• Recognised as part of the cost of an item of property, plant and equipment in
accordance with HKAS 16; and
HK(IFRIC)
Int-1.2 • Recognised as a liability in accordance with HKAS 37.
The scope of HK(IFRIC) Int-1 is, however, limited to addressing changes in the measurement
of existing decommissioning, restoration and similar liabilities caused by the following events:
• A change in the best estimate of resources embodying economic benefits required to
settle the obligation; and
• The provision is recognised at present value:
° when there is a change in the discount rate; and
HK(IFRIC)
Int-1.3
° when there is an increase in carrying amount due to the passage of time.
The occurrence of any of the above events will cause a change in the recognised amount
of the provision, per HKAS 37. Though one side of the journal entry records the change in
provision (i.e. CR (DR) for an increase (decrease)), the other side of the entry varies according
to the type of event that occurs and whether the entity measures the related item of property,
plant and equipment, per HKAS 16, using the cost or revaluation model.
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Change in Best Estimate/Discount Rate When Cost Model Used
HK(IFRIC)
The change in provision is matched by a corresponding adjustment to the cost of the related
Int-1.5(a) asset in the current period. For example, a change in best estimate that increases the
recognised amount of the provision (i.e. the CR entry) will increase the related asset by the
same amount (i.e. the DR entry).
In the event of a deduction from the cost of the asset, the amount deducted shall not
exceed its carrying amount. If the decline in the recognised amount of the provision exceeds
HK(IFRIC)
the carrying amount of the related asset, the excess is to be recognised in profit or loss in the
Int-1.5(b) current period.
In the event of an addition to the cost of the asset, the entity is to consider whether there is
HK(IFRIC)
an indication the asset’s new carrying amount exceeds its recoverable amount. If there is such
Int-1.5(c) an indication, the entity is to test the asset for impairment per HKAS 36 Impairment of Assets.
HK(IFRIC)
In subsequent periods, the adjusted depreciated amount of the asset is depreciated over its
Int-1.7 useful life.
Change in Best Estimate/Discount Rate When Revaluation Model Used
A decrease in a provision (i.e. the DR entry) is recognised in other comprehensive income and
increases the revaluation surplus within equity by a corresponding amount (i.e. the CR entry). If,
however, the decrease in provision (i.e. the DR entry) reverses a revaluation deficit on the asset
that was previously recognised in profit or loss, the amount of the decrease is recognised as a
HK(IFRIC)
Int-1.6(a)(i) gain (i.e. the CR entry) in profit or loss.
An increase in a provision (i.e. the CR entry) is recognised as an expense in profit or loss
(i.e. the DR entry). If, however, a credit balance exists in the revaluation reserve with respect to
that asset, the increase in provision (i.e. the CR entry) is correspondingly recognised in other
HK(IFRIC)
comprehensive income and reduces the revaluation surplus (i.e. the DR entry) to the extent of
Int-1.6(a)(ii) the credit balance.
Increase Due to Passage of Time
If an increase occurs in the carrying amount of the provision due to the passage of time (i.e. the
HK(IFRIC)
CR entry), the increase is recognised in profit or loss as a finance cost when it occurs (i.e. the
Int-1.8 DR entry).
Illustrative Example 11
On 1 January 20X2, Enertex Limited (Enertex) purchases a nuclear power plant for
HK$25 million and immediately begins using the plant to provide energy to the local
region. Under local law, Enertex is required to decommission the plant at the end of its
remaining useful life, which is estimated to be 50 years. Upon dismantling, the plant will
have zero scrap value. The cost of the plant for depreciation purposes is HK$30 million,
which includes Enertex’s initial best estimate of HK$5 million as the expected costs it will
incur to decommission the plant. Enertex recognises a decommissioning provision of
HK$5 million based upon this estimate. For the purposes of this illustration, ignore the
time value of money.
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Illustrative Example 11 (continued)
Enertex will depreciate the plant using the straight-line method and will use the cost
model to measure the plant over its useful life. Enertex’s reporting period end date is
31 December.
On 31 December 20X7, Enertex revises its best estimate of the decommissioning
costs to HK$4 million due to technological advances. Based upon an annual
depreciation charge of HK$600,000 (HK$30 million/50 years), the carrying amount of
the plant as of 31 December 20X7 is HK$26.4 million (HK$30 million – (HK$600,000 ×
6 years)).
As Enertex measures the plant using the cost model, the decrease in the
decommissioning provision (HK$1 million) is deducted from the cost of the plant.
Moreover, as the deduction (HK$1 million) does not exceed the carrying amount of
the plant (HK$26.4 million), Enertex can deduct the entire amount from the cost of
the plant. On 31 December 20X7, Enertex makes the following journal entry to reflect
the change:
Debit Credit
HK$ HK$
Decommissioning provision 1,000,000
Plant 1,000,000
Following the adjustment, the carrying amount of the plant is HK$25.4 million,
which will be depreciated over the remaining 44 years of the plant’s useful life.
Based upon this, depreciation expense for the next year will be HK$577,273
(HK$25,400,000/44 years).
Key Learning Point
To determine the appropriate accounting treatment of changes in the measurement
of existing provisions for decommissioning and restoration costs, it is essential to
establish the nature of the event causing the change and whether the entity adopts
the cost or revaluation model in measuring the related item of property, plant and
equipment.
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Knowledge Check Questions
Question 8
QRT Limited (QRT) is an authorised electricity retailer, competing with other electricity
retailers to offer electricity to residential and non-residential customers in Hong Kong. On
1 January 20X1, QRT enters into a contract with Retail Therapy Limited (Retail Therapy),
a shopping mall owner with 12 shopping malls located throughout Hong Kong, to supply
electricity to all shopping malls. The agreed upon price, fixed for three years, is HK$1.1 per
unit of electricity. Under the terms of the agreement, QRT and Retail Therapy are able to
exit the agreement at any time at a penalty of HK$2.225 million.
QRT sources its electricity from Premier Power Limited (Premier Power), a local power
company, that charges QRT HK$1.08 per unit of electricity. On 15 December 20X2, Premier
Power informs QRT that, due to a rise in fuel prices and an increase in direct labour
costs, it is increasing electricity charges to HK$1.2 per unit of electricity, effective close of
business on 31 December 20X2. Based upon experience, QRT estimates that Retail Therapy
will use 2,500,000 units of electricity for the 20X3 calendar year.
Following the announcement by Premier Power, QRT begins discussions with a
competing power company, Trans Fuel Limited (Trans Fuel), to become QRT’s electricity
supplier. To encourage QRT to switch power companies, Trans Fuel offers to subsidise
QRT for all existing electricity contracts with customers, with the subsidy being HK$0.02
per unit of electricity, provided QRT agrees to source all electricity from Trans Fuel from
1 January 20X4. QRT accepts the offer and enters into a contract with Trans Fuel on
30 December 20X2.
Explain how QRT should account for its contract with Retail Therapy as at 31 December
20X2.
Question 9
Depending upon your answer to Question 8, calculate the amount QRT should recognise
as a provision in relation to its contract with Retail Therapy as of 31 December.
A HK$0
B HK$200,000
C HK$2.225 million
D HK$3 million
1 8 . 7 DISCLOSURE
In addition to an entity recognising provisions in its statement of financial position, additional
information about the provisions is required to be disclosed in the accompany notes to the
financial statements. Moreover, though contingent liabilities and contingent assets are not
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recognised in an entity’s statement of financial position, the entity may be required to disclose
information in the notes accompanying the financial statements about such contingencies
to inform financial statement users about their existence, their nature and their estimated
financial effect.
18.7.1 Provisions
In accordance with HKAS 37, an entity must disclose the quantitative and qualitative
information about each class of provision.
For each class of provision, an entity is to disclose the following:
1. The carrying amount at the beginning and end of each period;
2. Additional provisions made in the period, including increases to existing provisions;
3. Amounts used (i.e. incurred and charged against the provision) during the period;
4. Unused amounts during the period;
5. The increase during the period in the discounted amount arising from the passage of
time and the effect of any change in the discount rate;
6. A brief description of the nature of the obligation;
7. The expected timing of any resulting outflows of economic benefits;
8. An indication of the uncertainties about the amount of timing of those outflows;
9. Where necessary to provide adequate information, the major assumptions made
concerning future events; and
HKAS 10. The amount of any expected reimbursement, stating the amount of any asset that has
37.84, 85 been recognised for that expected reimbursement.
HKAS Comparative information relating to prior periods is not required with respect to the first to
37.84 fifth items.
Illustrative Example 12
Roche Group is a global pharmaceuticals company headquartered in Switzerland. Roche
Group’s financial statements are prepared in accordance with International Financial
Reporting Standards (IFRSs). Hong Kong Financial Reporting Standards (HKFRSs) are
based upon IFRSs. The following are extracts of Roche Group’s note disclosures on
provisions from its 2021 annual Finance Report. As evident from the extracts, Roche
Group has five classes of provision, and for each class, it provides the information
required by HKAS 37.
An extract of the description of one class of provision (Restructuring) is provided.
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Illustrative Example 12 (continued)
20. Provisions and contingent liabilities
Provisions: movements in recognised liabilities in millions of CHF
Contingent
Legal Environmental Restructuring consideration Other
provisions provisions provisions provisions provisions Total
Year ended 31
December 2020
At 1 January 2020 882 503 1,194 205 1,616 4,400
Additional
provisions created 77 10 579 10 699 1,375
Unused
amounts reversed (423) (9) (82) (56) (345) (915)
Utilised (96) (53) (489) (9) (754) (1,401)
Discount unwind 4 0 7 0 7 0 14
Business
combinations
–A
cquired
companies 0 0 0 0 0 0
– Deferred
consideration – – – – 0 0
–C
ontingent
consideration – – – 0 – 0
Asset acquisitions 0 0 0 – 5 5
Currency
translation
effects (45) (15) (30) (7) (92) (189)
At 31
December 2020 395 443 1,172 150 1,129 3,289
Current 373 102 531 46 784 1,836
Non-current 22 341 641 104 345 1,453
At 31
December 2020 395 443 1,172 150 1,129 3,289
Year ended 31
December 2021
At 1 January 2021 395 443 1,172 150 1,129 3,289
Additional
provisions created 90 68 942 10 1,152 2,262
Unused
amounts reversed (12) (1) (147) (2) (232) (394)
Utilised (111) (56) (526) (23) (478) (1,194)
Discount unwind 4 0 4 0 2 0 6
Business
combinations
–A
cquired
companies 1 0 1 0 0 2
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Illustrative Example 12 (continued)
Provisions: movements in recognised liabilities in millions of CHF
Contingent
Legal Environmental Restructuring consideration Other
provisions provisions provisions provisions provisions Total
–D
eferred
consideration – – – – 0 0
–C
ontingent
consideration – – – 0 – 0
Asset acquisitions 0 0 0 – 0 0
Currency
translation
effects 9 (11) (15) 4 10 (3)
At 31
December 2021 372 447 1,427 141 1,581 3,968
Current 349 142 722 57 1,256 2,526
Non-current 23 305 705 84 325 1,442
At 31
December 2021 372 447 1,427 141 1,581 3,968
Expected outflow
of resources
Within one year 349 142 722 57 1,256 2,526
Between one
and two years 18 120 288 46 115 587
Between two and
three years 2 65 198 20 50 335
More than
three years 3 120 219 18 160 520
At 31
December 2021 372 447 1,427 141 1,581 3,968
In 2021 CHF 1,194 million of provisions were utilised (2020: CHF 1,401 million), of which CHF
1,166 million (2020: CHF 1,390 million) are included in the cash flows from operating activities and
CHF 28 million (2020: CHF 11 million) are included in the cash flows from business combinations for
payments made from deferred and contingent consideration arrangements (see Note 6).
Restructuring provisions
These arise from planned programmes that materially change the scope of business undertaken
by the Group or the manner in which business is conducted. Such provisions include only the costs
necessarily entailed by the restructuring which are not associated with the recurring activities of
the Group. The timings of these cash outflows are reasonably certain. These provisions are not
discounted as the time value of money is not material in these matters.
In the Pharmaceuticals Division, the significant provisions relate to various business transformation
initiatives, including the resourcing flexibility plans and the site development plans at the Basel
and Kaiseraugst site, as well as to the redesign and the strategic realignment of its manufacturing
network. In the Diagnostics Division, the significant provisions are associated with programmes to
address long-term strategy, while in Corporate they relate to initiatives for the outsourcing of IT and
other functions to shared service centres and external providers.
Source: Roche Group Finance Report 2021
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It may be, albeit in rare cases, that some or all of the preceding disclosures prejudices an
entity’s position in a dispute on the subject matter of the provision. In such cases, an entity is
not required to disclose such information but is required to disclose:
• The general nature of the dispute; and
HKAS
37.92 • The fact that, and the reason why, the information has not been disclosed.
18.7.2 Contingent Liabilities
Having established that a contingent liability exists, an entity must then determine whether
it is required to disclose information about the contingent liability. Being required to disclose
information about the contingent liability depends upon the likelihood that an outflow of
economic benefits will be required to settle the liability. If the likelihood of settlement is
remote, no information is to be disclosed about the contingent liability. If it is more likely than
remote that settlement will occur, for each class of contingent liability, an entity is to disclose
the following:
• A brief description of the nature of the contingent liability and, where practicable,
• An estimate of its financial effect, and
• An indication of the uncertainties relating to the amount or timing of any outflow, and
HKAS
37.86 • The possibility of any reimbursement.
HKAS In estimating the financial effect of a contingent liability, an entity is to apply the same
37.86(a) measurement requirements as a provision. That is, an entity is to determine the best estimate
of the expenditure required to settle the contingent liability at the end of the reporting period,
taking into account:
• The risks and uncertainties of possible outflows occurring;
• The occurrence of future events (supported by objective evidence) that affect the
amount required to settle the contingent liability; and
• The time value of money, if material.
A discussion of the above measurement requirements in the context of provisions is
provided in Section 18.3 of this chapter.
Illustrative Example 13
Below is an extract of the note disclosures about contingent liabilities provided in
the 2021 Annual Report of Alcon Inc, a pharmaceutical company based in Geneva,
Switzerland. Alcan Inc’s financial statements are prepared in accordance with
International Financial Reporting Standards (IFRSs). Hong Kong Financial Reporting
Standards (HKFRSs) are based upon IFRSs.
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Illustrative Example 13 (continued)
26. Commitments and Contingencies
Contingencies
The Alcon companies have to observe the laws, government orders and regulations of the country in
which they operate.
A number of Alcon companies are, and will likely continue to be, subject to various legal proceedings
and investigations that arise from time to time, including proceedings regarding product liability,
sales and marketing practices, commercial disputes, employment, and wrongful discharge, antitrust,
securities, health and safety, environmental, tax, international trade, privacy, and intellectual
property matters. As a result, Alcon may become subject to substantial liabilities that may not be
covered by insurance and could affect Alcon’s business, financial position and reputation. While
Alcon does not believe that any of these legal proceedings will have a material adverse effect on its
financial position, litigation is inherently unpredictable and large judgments sometimes occur. As a
consequence, Alcon may in the future incur judgments or enter into settlements of claims that could
have a material adverse effect on its results of operations or cash flow.
While provisions have been made for probable losses, which management deems to be reasonable
or appropriate, there are uncertainties connected with these estimates. Note 19 contains additional
information on these matters.
Alcon is involved in legal proceedings concerning intellectual property rights. The inherent
unpredictability of such proceedings means that there can be no assurances as to their ultimate
outcome. A negative result in any such proceeding could potentially adversely affect the ability of certain
Alcon companies to sell their products, or require the payment of substantial damages or royalties.
Alcon’s potential for environmental remediation liability is assessed based on a risk assessment
and investigation of the various sites identified by Alcon as at risk for environmental remediation
exposure. Alcon’s future remediation expenses are affected by a number of uncertainties. These
uncertainties include, but are not limited to, the method and extent of remediation, the percentage
of material attributable to Alcon at the remediation sites relative to that attributable to other parties,
and the financial capabilities of the other potentially responsible parties.
Alcon has no significant environmental liabilities as at December 31, 2021 and 2020 and has incurred
no significant remediation costs for the years ended December 31, 2021, 2020 and 2019.
Source: Alcon Inc Annual Report 2021, pages F60 to F61
HKAS Where it is impracticable for an entity to disclose any of the required information, that fact
37.91 is to be disclosed by the entity.
It may be, albeit in rare cases, that some or all of the preceding disclosures prejudices an
entity’s position in a dispute on the subject matter of the contingent liability. In such cases, an
entity is not required to disclose such information, but is required to disclose:
• The general nature of the dispute; and
HKAS
37.92 • The fact that, and the reason why, the information has not been disclosed.
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Key Learning Point
It is important to identify whether the likelihood of settling a contingent liability is
remote or more likely than remote, and it is important to determine whether an entity is
required to disclose information about the contingent liability in the notes to the financial
statements.
18.7.3 Contingent Assets
When an entity establishes the existence of a contingent asset, it must then determine whether
it is required to disclose information about the contingent asset. Whether information is to
be disclosed about a contingent asset depends upon the likelihood of an inflow of economic
benefits being received by the entity. If an inflow of economic benefits will probably not be
received, no information is to be disclosed about the contingent asset.
If an inflow of economic benefits will probably be received (but not certain, as this would
give rise to an asset being recognised), an entity is to disclose the following:
• A brief description of the nature of the contingent asset; and
HKAS
37.89 • where practicable, an estimate of its financial effect.
HKAS Where it is impracticable for an entity to disclose any of the required information, that fact
37.91 is to be disclosed by entity.
It may be, albeit in rare cases, that some or all of the preceding disclosures prejudices an
entity’s position in a dispute on the subject matter of the contingent asset. In such cases, an
entity is not required to disclose such information but is required to disclose:
• The general nature of the dispute; and
HKAS
37.92 • The fact that, and the reason why, the information has not been disclosed.
Knowledge Check Questions
Question 10
Continuing with the facts provided in Question 7, apply the disclosure requirements of
HKAS 37 and prepare the note Farm Supplies will disclose for the reporting period ended
31 December 20X2. Assume there are no other provisions.
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1 8 . 8 CURRENT DEVELOPMENTS
At the time of writing, one active project is on the International Accounting Standards Board’s
(IASB’s) agenda relating to IAS 37 Provisions, Contingent Liabilities and Contingent Assets, thereby
affecting HKAS 37. The project is outlined in Exhibit 18.8.
Project About the project
Provisions - Targeted Evidence gathered by the IASB has identified three areas of improvement
Improvements the Board has been targeting:
1. Apparent contradictions within the principles in IAS 37 for
identifying liabilities, which have resulted in inconsistent
application requirements. For example, IFRIC 21 Levies (IFRIC 21),
an interpretation of IAS 37, has been criticised for resulting in
information that is not useful to investors. The contradictions centre
on whether and, if so, when an obligation conditional on an entity’s
own future actions is a ‘present obligation’ and, hence, a liability.
Because of this question’s cross-cutting nature, the IASB addressed it
as part of its Conceptual Framework project, and is now applying the
concepts set out in Conceptual Framework to develop its proposals
to amend IAS 37. The amendments are likely to include replacing
IFRIC 21 with new application requirements for levies;
2. Whether a provision for an obligation to deliver goods or services
should comprise only the incremental costs of fulfilling the obligation
or also include an allocation of other directly related costs. In May
2020, the IASB issued Onerous Contracts – Cost of Fulfilling a Contract,
which made amendments to IAS 37. The amendments specify which
costs an entity includes in determining the cost of fulfilling a contract
for the purpose of assessing whether the contract is onerous;
3. Whether the rate at which an entity discounts a provision for the time
value of money should reflect the entity’s own credit risk (i.e., the
possibility that it may fail to fulfil its obligation).
In February 2022, the IASB reviewed the project’s prospects for
progress and concluded that efficient progress is possible. Therefore,
the IASB decided to keep the project on its work plan.
You can follow the project on the IASB website at:
https://www.ifrs.org/projects/work-plan/provisions/#current-stage.
EXHIBIT 18.8 Project on IASB’s Agenda relating to IAS 37
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SUMMARY
• An entity is to apply the requirements of HKAS 37 when accounting for, and disclosing
information about, provisions, contingent liabilities and contingent assets.
Provisions
• A provision is distinguishable from certain other liabilities because there is uncertainty about
the timing or amount of the future expenditure required to settle the liability.
• Under HKAS 37, an entity must recognise a provision as a liability when:
a) The entity has a present obligation (legal or constructive) as a result of a past event;
b) An outflow of resources embodying economic benefits will probably be required to settle
the obligation; and
c) A reliable estimate can be made of the amount of the obligation.
• An entity must recognise a provision at an amount that is the best estimate of the expenditure
required to settle the present obligation at the end of the reporting period.
• HKAS 37 states that, in measuring a provision, an entity is to:
° Take risks and uncertainties into account, but not so as to create excessive provisions or a
deliberate overstatement of liabilities;
° Discount the provision, where the effect of the time value of money is material, using a
pre-tax discount rate that reflects current market assessments of the time value of money
and those risks specific to the entity that have not been reflected in the best estimate of
the expenditure;
° Take future events into account where there is sufficient objective evidence they will
occur; and
° Not take gains from the expected disposal of assets into account.
• Under HKAS 37, an entity is to review its provisions at the end of each reporting period and
make adjustments to the provisions’ carrying amounts to reflect their current best estimate.
• An entity must not recognise provisions for future operating losses.
• If an entity has a onerous contract, the present obligation under the contract must be
recognised and measured, by an entity, as a provision.
° A contract is onerous if the unavoidable costs of meeting the obligations under the
contract exceed the economic benefits expected to be received under it.
° The provision is measured as the lower of the cost of fulfilling the contract and the cost of
compensation or penalties to exit the contract.
• An entity is to recognise a provision for restructuring costs only when the general recognition
criteria for provisions are met. If, upon applying guidelines specific to restructuring plans,
the general recognition criteria are satisfied, a restructuring provision is to be measured by
including only those direct expenditures arising from the restructuring.
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• For each class of provision, an entity is to disclose the following:
° The carrying amount at the beginning and end of each period;
° Additional provisions made in the period, including increases to existing provisions;
° Amounts used (i.e. incurred and charged against the provision) and unused during
the period;
° The increase during the period in the discounted amount arising from the passage of time
and the effect of any change in the discount rate;
° A brief description of the nature of the obligation;
° The expected timing of any resulting outflows of economic benefits and an indication of
the uncertainties about the amount and timing of those outflows;
° The major assumptions made concerning future events; and
° The amount of any expected reimbursement.
Contingent Liabilities
• A contingent liability is distinguishable from a provision in two potential ways:
° A contingent liability is a ‘possible’ obligation of an entity whereas a provision is a ‘present’
obligation of the entity; or
° A contingent liability (like that of a provision) is a ‘present’ obligation of an entity but
fails the general recognition criteria that a provision satisfies (i.e. probable outflow of
resources embodying economic benefits and/or a reliable estimate of the obligation).
• An entity is not to recognise a contingent liability.
• If settlement of a contingent liability is not remote, for each class of contingent liability, an
entity must disclose a brief description of the nature of the contingent liability and, where
practicable:
°° an estimate of its financial effect;
°° an indication of the uncertainties relating to the amount or timing of any outflow; and
°° the possibility of any reimbursement.
Contingent Assets
• An entity is not to recognise a contingent asset.
• If an inflow of economic benefits will be probably received (but not nearly certain as this
would give rise to an asset being recognised), an entity is to disclose the following:
° a brief description of the nature of the contingent asset; and
° where practicable, an estimate of its financial effect.
• When the inflow of economic benefits is nearly certain, then the item is not a contingent asset
and its recognition is appropriate.
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MIND MAP
PROVISIONS – GENERAL PRINCIPLES SCOPE OF HKAS 37
Definition Applies to all provisions, contingent
• A liability of uncertain amount or timing liabilities and contingent assets, except
Recognition those in relation to
• Recognised as a liability when: • Executory contracts, unless onerous;
- A present obligation (legal or constructive) • Financial instruments within the scope
exists as a result of a past event; of HKFRS 9;
- It is probable that an outflow of resources • Income taxes;
embodying economic benefits will be • Leases, except to any lease that becomes
required to settle the obligation; and onerous before the lease commences, or
- A reliable estimate can be made of the to short-term or low-value leases that have
amount of the obligation become onerous;
• If these conditions are not met, no • Employee benefits;
provision is recognised but a contingent • Insurance contracts;
liability may exist • Contingent consideration in a business
combination; and
Measurement
• Revenue from contracts with customers,
• The best estimate of the expenditure
unless onerous
required to settle the present obligation
at the end of the reporting period CONTINGENT LIABILITIES
• In measuring a provision, an entity is to:
- Take risks and uncertainties into account Definition
to the extent it does not cause the • It is:
provision to be excessive; - A possible obligation that arises from
- Discount the provision using a pre-tax past events and whose existence will be
discount rate, where the time value of confirmed only by the occurrence or
PROVISIONS, non-occurrence of one or more uncertain
money is material;
CONTINGENT future events not wholly within the control
- Take future events into account where
LIABILITIES AND of the entity; or
sufficient objective evidence exists that
CONTINGENT ASSETS - A present obligation that arises from past
they will occur;
(HKAS 37) events but is not recognised because:
- Ignore the expected disposal of assets,
even if closely linked to the event giving ° It is not probable that an outflow of
rise to the provision resources embodying economic benefits
• Expected reimbursement of some or all will be required to settle the obligation; or
of the expenditure required to settle ° The amount of the obligation cannot be
a provision is accounted for separately measured with sufficient reliability
from the provision Recognition
Changes to Provisions • A contingent liability is not to be recognised
• Provisions are to be reviewed at the end Disclosure
of each reporting period and adjusted to • If the likelihood of settlement is remote:
reflect the current best estimate, including - No information is disclosed
reversing the provision if an outflow is no • If it is more likely than remote that settlement
longer probable will occur: disclose:
Disclosure - A brief description of the nature of the
• For each class of provision: contingent liability; and, where practicable,
- The carrying amount at the beginning an estimate of its financial effect
and end of the period; additional
CONTINGENT ASSETS
provisions made in the period, including
increases to existing provisions; amounts Definition
used and unused during the period; • A possible asset that arises from past events
unused amounts reversed during the and whose existence will be confirmed only
period; a brief description of the nature by the occurrence or non-occurrence of one
of the obligation; the expected timing of or more uncertain future events not wholly
any resulting outflow of economic within the control of the entity
benefits; and an indication of the Recognition
uncertainties about the amount or • A contingent asset is not to be recognised
timing of those outflows
Disclosure
PROVISIONS – SPECIFIC APPLICATIONS • If it is not probable an inflow of economic
benefits will be received:
Future Operating Losses - No information is disclosed
• A provision is not to be recognised for future operating losses • If it is probable (but not virtually certain)
Onerous Contracts an inflow of economic benefits will be
• A contract in which the unavoidable costs in meeting the received, disclose:
contractual obligations exceed the expected economic benefits - A brief description of the nature of the
to be received. If a contract is onerous, the present obligation contingent asset; and, where practicable,
under the contract is to be recognised and measured as a provision an estimate of its financial effect
Reinstatement of Premises
• Present obligation to reinstate premises is to be recognised as
provision, measured at the expected costs of reinstatement
Restructuring Activities
• Direct expenditures that will arise from expected restructuring
activities are recognised as a provision if specific guidelines
related to the general recognition criteria for provisions are met
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Answers to Knowledge Check Questions
Question 1
Answer A is incorrect. Bonus payments constitute employee benefits, and thus, the
obligation to make such payments is governed by HKAS 19 Employee Benefits.
Answer B is incorrect. A contract between an insurer and policyholder is an insurance
contract, and as such, an obligation arising from that contract is governed by HKFRS 17
Insurance Contracts.
Answer C is correct. A contractual obligation to repair defective products returned within
the warranty period does not fall within the specific requirements of other standards and,
as such, is within the scope of HKAS 37
Answer D is incorrect. The contractual obligation to provide cleaning services to a customer
is an example of a performance obligation arising from a contract with a customer and,
thus, is governed by HKFRS 15 Revenue from Contracts with Customers.
Question 2
As of 31 December 20X4, GlamRock is subject to a contingent liability. HKAS 37
acknowledges that in rare instances, such as a lawsuit, whether a present obligation
exists may be unclear, and an entity must make a judgement about whether a present
obligation exists based upon all available evidence. If Glamrock believes it dismissed the
former employee in accordance with the employment contract, supported by Glamrock’s
lawyers advising that GlamRock will probably not be found liable, it may conclude that a
present obligation does not exist. If so, GlamRock is subject to a possible obligation whose
occurrence is confirmed by the occurrence of an uncertain future event (namely, the court
deciding in favour of the former employee, and awarding damages), which constitutes a
contingent liability.
Whether Glamrock would be required to disclose information about the contingent
liability, and the type of information to disclose, is considered in Section 18.7 of
this chapter.
Question 3
As of 31 December 20X5, GlamRock would recognise a provision based upon the
following analysis:
Criteria Application
Present obligation as a result of The termination of the employee is the obligating event. By
a past event terminating the former employee in the manner in which it did,
GlamRock created a legal obligation to compensate the former
employee for breaching an implied duty of trust and confidence.
Probable outflow of resources An outflow of resources will probably be required to settle the
embodying economic benefits legal obligation as GlamRock has no realistic alternative but to
to settle the obligation pay the damages.
Reliable estimate can be made As HKAS 37 states, in rare cases, a reliable estimate of the
of the amount of the obligation obligation cannot be made. GlamRock will be able to determine
a range of possible amounts payable as damages, including
HK$10 million, and make an estimate sufficiently reliable to
warrant recognising a provision.
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Question 4
Scoot Around is to recognise a provision if there is: (a) a present obligation as a result of a
past event; (b) it is probable an outflow of resources embodying economic benefits will be
required to settle the obligation; and (c) a reliable estimate of the amount of the obligation
can be made.
Criteria Application
(a) The sale of the scooters is the obligating event. Scoot Around is subject to a
legal obligation to fulfil the warranty commitments that arise at the time of sale.
The obligation is legal, as opposed to constructive, because it is the terms within
the sales contract that oblige Scoot Around to cover the cost of repairs on defective
scooters returned within nine months of purchase.
(b) When considering the population of warranty obligations as a whole, some
scooters sold under warranty will probably be faulty and require repair. As such,
an outflow of resources (i.e. the cost of labour and materials) will probably be
required to settle the legal obligation.
(c) Scoot Around measures its warranty provision as the expected value of the
cost of repairs by weighting all possible outcomes by their differing associated
probabilities, which equals:
(70% × HK$0) + (20% × HK$2 million) + (10% × HK$6 million) = HK$1 million
Question 5
GlamRock continues to recognise a provision as there is still some uncertainty about
the outflow amount required to settle the obligation. This uncertainty arises because
GlamRock has appealed the amount of damages awarded against it, and the appeal is yet
to be heard by the court of appeal. GlamRock is, however, able to make a reliable estimate
of the amount of the obligation using HK$5 million as the best estimate.
As the effect of the time value of money is material, GlamRock must recognise a
provision at an amount that equals the present value of the expected expenditure required
to settle the damages claim.
GlamRock is to use a pre-tax discount rate that reflects the current market
assessments of the time value of money and the risks specific to the damages claim.
Though not specific to the damages claim, the corporate bond rate offered by GlamRock
does factor in market and entity-specific risks and may act as an appropriate proxy.
As of 31 December 20X6, GlamRock would recognise a provision that equals
HK$4,772,189, calculated as follows:
Year Estimated future Discount Present value of
cash outflows rate future cash outflows
HK$ HK$
1 January 20X7 1,000,000 1,000,000
1 January 20X8 2,000,000 1/1.04 1,923,077
1 January 20X9 2,000,000 1/1.04 2
1,849,112
Present value 4,772,189
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FINANCIAL REPORTING
Question 6
As the effect of the time value of money is material, Farm Supplies must recognise a
provision at an amount that equals the present value of the expected expenditure required
to settle the future warranty claim.
As risk has been factored into the expected future cash outflow, no further adjustment
for risk is made to the discount rate. As such, Farm Supplies discounts the expected future
cash outflow to present value using the 4% pre-tax, risk-free rate on government bonds
with the same term (i.e. three years).
Based upon this information, the following table shows the present value of the future
expenditure for each of the three years:
Year Borrowing cost Cash payment Present value
HK$ HK$ HK$
31 December 20X0 84,555
31 December 20X1 84,455 × 4% = 3,378 – 87,833
31 December 20X2 87,833 × 4% = 3,513 – 91,346
31 December 20X3 91,346 × 4% = 3,654 (95,000) 0
As evident from the table, HK$95,000 is the amount of expenditure that will be required in
three years (31 December 20X3) to repair the hydraulics. The present value of the expected
future expenditure as of 31 December 20X0 (based upon the present value of the future
expenditure on 1 January 20X1) is HK$84,455 (95,000/1.043). This is the best estimate of
the expenditure required to settle the warranty claim at the end of the current reporting
period (20X0) and is the amount at which the warranty provision is initially recognised.
The following journal entry on 31 December 20X0 records the initial recognition of the
provision:
Debit Credit
HK$ HK$
Warranty costs 84,455
Warranty provision 84,455
As evident from the above table, the present value of HK$95,000 increases with the
passage of time. In accordance with HKAS 37, the annual increase in the warranty provision
is recognised as a borrowing cost in Farm Supplies’ statement of profit or loss.
The following journal entries on 31 December 20X1, 20X2 and 20X3 record the increase
in present value in each respective year:
Date Description Debit Credit
20X1 HK$ HK$
31 December Borrowing cost 3,378
Warranty provision 3,378
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P rovisions , C ontingent L iabilities and Contingent Assets
Date Description Debit Credit
20X2 HK$ HK$
31 December Borrowing cost 3,513
Warranty provision 3,513
Date Description Debit Credit
20X3 HK$ HK$
31 December Borrowing cost 3,654
Warranty provision 3,654
Assuming Farm Supplies’ expectations are accurate, the following journal entry will
take place on 31 December 20X3 to record the settlement of the warranty provision:
Debit Credit
HK$ HK$
Warranty provision 95,000
Cash 95,000
The cash outflow relates to the cost of materials and labour paid for to repair the
defective hydraulics.
Question 7
On 31 December 20X2, Farm Supplies now estimates it will pay HK$80,000 on 31 December
20X3 to settle the warranty provision. The present value of HK$80,000 on 31 December
20X2 is HK$76,923 (HK$80,000/1.04).
In accordance with HKAS 37, Farm Supplies must adjust the carrying amount of the
warranty provision to reflect its revised best estimate. From the previous question, the
carrying amount of the provision as of 31 December 20X2 is HK$91,346. A HK$14,423
reduction to the carrying amount of the provision is required (HK$91,346 – HK$76,923),
with the following journal entry recorded on 31 December 20X2:
Debit Credit
HK$ HK$
Warranty provision 14,423
Warranty costs 14,423
Following adjustment, the present value of the warranty provision will increase with
the passage of time. Prior to settlement, on 31 December 20X3, the HK$3,077 (HK$76,923 ×
4%) increase in the warranty provision is recognised as a borrowing cost with the following
journal entry:
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FINANCIAL REPORTING
Debit Credit
HK$ HK$
Borrowing cost 3,077
Warranty provision 3,077
The following journal entry will then take place on 31 December 20X3 to record the
settlement of the warranty provision:
Debit Credit
HK$ HK$
Warranty provision 80,000
Cash 80,000
Question 8
Due to Premier Power increasing the electricity costs per unit charged to QRT, effective
31 December 20X2, from that date onward, QRT is a party to an onerous contract between
itself and Retail Therapy. The contract is onerous because the unavoidable costs of
meeting the obligations under the contract (i.e. the electricity charges of HK$1.20 per unit
of electricity to be paid to Premier Power) exceed the economic benefits of HK$1.12 per
unit of electricity expected to be received under it (i.e. the electricity payments of HK1.10 to
be received from Retail Therapy plus the subsidy of HK$0.02 offered by Trans Fuel).
Under HKAS 37 QRT is to recognise a provision, supported by the following analysis:
Criteria Application
Present obligation as a result of a The signing of the supply contract is the obligating
past event event, for example, entering into the contract with Retail
Therapy created a legal obligation to comply with the
terms of the agreement.
Probable outflow of resources Upon the supply contract with Retail Therapy becoming
embodying economic benefits to onerous on 31 December 20X2, an outflow of resources
settle the obligation embodying economic benefits is probable.
Reliable estimate can be made of A provision is to be recognised at the least net cost of
the amount of the obligation exiting from the supply contract which, as indicated in
Question 9, can be reliably estimated.
From the date the contract becomes onerous (31 December 20X2), QRT must account
for the contract in accordance with HKAS 37 by recognising a provision.
Question 9
Answer A is incorrect. This option assumes that QRT is not party to an onerous contract and,
therefore, is not required to recognise a provision. Based upon the answer to Question 8,
this assumption is incorrect.
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Answer B is correct. QRT must measure the provision at the lower of: (a) the cost of
fulfilling the contract; and (b) the cost of any compensation or penalties arising from failing
to fulfil the contract. Under option (a), the cost of fulfilling the contract is equal to:
• Costs payable to Trans Power in the final year of the contract (HK$1.2 per unit of
electricity × 2,500,000 units of electricity = HK$3 million); minus the
• Amount receivable from Retail Therapy in the final year of the contract (HK$1.1 per
unit of electricity × 2,500,000 units of electricity = HK$2.75 million) and the subsidy
from Trans Fuel of HK$50,000 (HK$0.02 per unit of electricity × 2,500,000 units of
electricity).
That is, HK$3 million – (HK$2.75 million + HK$50,000) = HK$200,000.
Under option (b), the penalty for exiting the contract early is HK$2.225 million. As
the cost of option (a) is less than the cost of option (b), QRT will recognise a provision at
HK$200,000.
Answer C is incorrect. This amount is the penalty for exiting the contract early but is higher
than the cost of fulfilling the contract.
Answer D is incorrect. This amount is the cost payable to Trans Power in the final year of
the contract but fails to subtract the amount receivable from Retail Therapy in the final
year of the contract in calculating the cost of fulfilling the contract.
Question 10
Note XX: Warranty Provision
Changes in the warranty provision for 20X2 were as follows:
Changes in warranty provision
HK$
31 December 20X1 87,833
Reversal (14,423)
Borrowing cost 3,513
31 December 20X2 76,923
The warranty provision recognised in the statement of financial position as of 31 December
20X2 is expected to be utilised as follows:
Expected utilisation of warranty provision
HK$
20X2 76,923
Total 76,923
Farm Supplies manufactured a customised fertiliser distributor and applicator,
accompanied by a five-year warranty. Two of the five years of the warranty period have
expired. Farm Supplies uses prior experience to estimate the expenditure to be incurred,
and its timing, to satisfy the warranty obligation, but both are subject to uncertainty.
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FINANCIAL REPORTING
EXAM PRACTICE
QUESTION 1
Fine Print Limited (Fine Print) is a manufacturer of printers. 24/7 Office Limited (24/7 Office)
operates a chain of office supplies stores throughout Asia. On 1 January 20X1, Fine Print
enters into a non-cancellable, three-year contract with 24/7 Office to supply its most highly
regarded product, the ‘A1’ printer, in all 24/7 Office stores at a discounted wholesale price
of HK$950 per printer. The cost of manufacturing the ‘A1’ printer is HK$925. As part of the
agreement, Fine Print offers a rolling 12-month warranty over the duration of the three-year
contract, where Fine Print will repair any defects free to 24/7 Office customers within the
first 12 months of purchase. That is, though the warranty period is 12 months, it will apply
to any purchase occurring during the three-year contract (subject to being returned within
12 months of the purchase). At the time of signing the agreement, the outstanding warranty
commitments relating to other sales by Fine Print equals HK$390,000. These commitments
relate to warranties provided over a three-year period, with outflows expected to occur
evenly over each period.
Based upon experience, Fine Print estimates that 0.5% of 20X1 orders by 24/7 Office will
be returned by 24/7 Office customers for repair and estimates the cost of repairs for each
unit to be equal to the unit’s wholesale price. 24/7 Office orders 1,000,000 ‘A1’ printers for
the first 12 months of the contract, all of which have been sold by year-end. By 31 December
20X1, Fine Print spends HK$4.5 million on materials and labour costs to repair ‘A1’ printers
returned during the warranty period.
On 1 March 20X2, Fine Print sources a new supplier for the drum component of the ‘A1’
printer, which was the main cause of 20X1 defects. Upon sourcing the new supplier, the cost
of manufacturing the ‘A1’ printer increases to HK$960. Fine Print approaches 24/7 Office
about renegotiating the wholesale price of the ‘A1’ printer for the final two years of the
contract. 24/7 Office does not agree to this amendment.
Due to the new drum supplier, Fine Print now estimates that 0.3% of 20X2 sales will be
returned by 24/7 Office customers for repair. For the year ended 31 December 20X2, 24/7
Office orders 900,000 ‘A1’ printers and Fine Print spends HK$2.25 million on costs repairing
‘A1’ printers returned during the warranty period.
24/7 Office has indicated it will order 800,000 ‘A1’ printers for the final year of the contract.
Required:
(a) Advise Fine Print how it is to account for its warranty commitments in its financial
statements for the reporting period ended 31 December 20X1, including any note
disclosures. Assume that no adjustment is needed for the time value of money.
(b) Advise Fine Print how it must account for its warranty commitments and its contract
with 24/7 Office in its financial statements for the reporting period ended 31 December
20X2, including any note disclosures.
QUESTION 2
On 1 January 20X4, HKOil Limited (HKOil) enters into a production sharing agreement with
the government of Latma, an African nation, to construct an offshore drilling rig and extract
petroleum off the western coast of Africa for a period of 50 years. The coastal waters
where the rig is to be constructed is within the jurisdiction of Latma. Construction begins
immediately and is completed on 31 December 20X4 at a cost of HK$125 mllion. As part
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P rovisions , C ontingent L iabilities and Contingent Assets
of the agreement, HKOil is to remove the drilling rig when extraction ceases. After taking
account of risk and the time value of money, HKOil estimates it will cost HK$17.5 million to
dismantle and remove the rig. Petroleum extraction begins on 31 December 20X4.
On 1 May 20X5, a ruptured pipeline causes the spillage of millions of litres of petroleum
into the neighbouring waters before the leak was stopped. At the time of the spillage, there
was no legal requirement for HKOil to rectify the contamination caused. It is HKOil’s business
custom not to rectify contamination unless there is a legal responsibility to do so. On
1 November 20X5, the government of Latma introduces a legislative bill requiring oil and gas
companies to rehabilitate any existing environmental damage caused by extracting Latma’s
natural resources. The legislative bill is enacted as law on 1 March 20X6 and is to be applied
retrospectively. After taking into account risk and the time value of money, HKOil estimates
it will cost HK$8 million to rectify the damage caused by the 1 May 20X5 spillage.
On 1 December 20X5, the management of HKOil has obtained independent advice
from construction engineers that, by the time the rig is to be dismantled, technological
advancements will be such the cost of dismantling will be less than that currently estimated.
The engineers estimate such cost reductions will be approximately HK$3.25 million.
HKOil depreciates the rig using the straight-line method and, from 20X5 onwards, uses
the revaluation model to measure the rig over its useful life. At 31 December 20X5, the fair
value of the rig is HK$145 million. HKOil’s reporting period end date is 31 December. HKOil
authorised its 20X5 financial statements on 25 March 20X6.
Required:
Advise HKOil how it is to account for its commitments stemming from the agreement with
Latma for the reporting periods ended 31 December 20X4 and 20X5.
QUESTION 3
(Adapted from Module A December 2015 Paper)
Forest Electricity Limited (FEL) is a manufacturer of electricity appliances that owned two
manufacturing plants in the mainland China and one retail shop in Hong Kong. FEL has
incurred losses in its operation of manufacturing and retailing businesses. During its
financial year ended 31 December 20X4, the following transactions have taken place:
• Due to the poor performance of FEL, the management has decided to terminate the
operation of one of the manufacturing plants on 1 December 20X4 though it has
not announced this to all the employees on 31 December 20X4. In the year 20X5, it
is expected to incur operational costs of HK$8 million, cost of relocation of staff of
HK$1 million and dismantling cost of plant of HK$4 million.
• FEL has a long-term supply contract with a customer to provide 100,000 Product X
at HK$20 each every year for a term of three years from 1 April 20X4 to 31 March
20X7. Up to 31 December 20X4, FEL has delivered 50,000 Product X to the customer.
Because of the increased material costs, the manufacturing cost is expected to be
HK$22 each from 1 January 20X5 onwards.
Required:
Advise FEL as to the accounting implications for each of the costs incurred in 20X4 and 20X5,
and calculate the amounts to be recognised for each of the above events by FEL for the year
ended 31 December 20X4.
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FINANCIAL REPORTING
ANSWERS TO EXAM PRACTICE
QUESTION 1
(a) In accordance with HKAS 37, Fine Print is to recognise a provision for the 20X1
reporting period relating to its warranty commitments under the agreement with 24/7
Office. This assessment is reached based upon applying the general recognition criteria
of HKAS 37, as follows:
Criteria Application
Present obligation as a result of a The sale of the ‘A1’ printer to 24/7 Office customers is
past event the past obligating event. When signing the agreement,
Fine Print commits to repairing defective printers
returned within the warranty period. However, the legal
obligation to another party (i.e. the customer) to repair a
defective printer does not arise until the sale occurs.
Probable outflow of resources Considering individual warranty obligations as a
embodying economic benefits to collective, some customers will probably return their
settle the obligation ‘A1’ printer purchases for repair. As such, an outflow of
resources (i.e. labour and materials costs) will probably
be required to settle the legal obligation.
Reliable estimate can be made of Based upon experience, Fine Print estimates its warranty
the amount of the obligation obligations on the ‘A1’ printer as 0.5% of current
period sales.
In measuring the warranty provision, Fine Print’s best estimate of the expenditure
required to settle its warranty obligations is HK$4.75 million (HK$950 × 1,000,000 sales
× 0.5%). The warranty provision is raised by the following journal entry:
Debit Credit
HK$ HK$
Warranty costs 4,750,000
Warranty provision 4,750,000
The materials and labour costs of HK$4.5 million are charged against the warranty
provision, as reflected in the following journal entry:
Debit Credit
HK$ HK$
Warranty provision 4,500,000
Cash 4,500,000
Assuming no other transactions are in relation to Fine Print’s warranty provision,
the note disclosure for the 20X1 financial statements is as follows:
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Note XX: Warranty Provision
Changes in the warranty provision for 20X1 were as follows:
Changes in warranty provision
HK$
31 December 20X0 390,000
Additions 4,750,000
Utilisation (4,630,000)1
31 December 20X1 510,000
The warranty provision recognised in the statement of financial position as of
31 December 20X1 is expected to be utilised as follows:
Expected utilisation of warranty provision
HK$
20X2 213,333
20X3 213,3332
20X4 83,3343
Total 510,000
Note:
1
20X1: HK$4.5 million + (HK$390,000/3 years).
2
20X2 and 20X3: ((HK$4.75 million – HK$4.5 million)/3 years) + (HK$390,000/3 years).
3
20X4: ((HK$4.75 million – HK$4.5 million)/3 years).
Fine Print offers warranties on all printer sales with warranty periods ranging from
12 months to three years. Our primary warranty commitments relate to a three-year
agreement with a major customer, where a 12-month warranty period is offered.
One of the three years of the agreement has expired. Fine Print uses prior experience
to estimate the expenditure to be incurred, and its timing, to satisfy the warranty
obligation, but both are subject to uncertainty.
As evident from the note disclosure, utilisation of the warranty provision in
20X1 includes the amount of costs incurred to repair defective ‘A1’ printers as well
as the outflows relating to the other warranty commitments (i.e. HK$4.5 million +
(HK$390,000/3 years) = HK$4.63 million).
As of 31 December 20X1, two years are remaining on the other warranty
commitments of Fine Print, and three years are remaining on the warranty
commitments on the agreement with the 24/7 Office (i.e. two years remaining on the
24/7 Office contract plus another 12 months for sales that occur in the final year of
the contract). The carrying amount of the warranty provision at the end of the 20X1
reporting period relating to other warranty commitments (HK$260,000) is expected
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FINANCIAL REPORTING
to be utilised equally over a two-year period (i.e. HK$130,000 in 20X2 and 20X3).
The carrying amount of the warranty provision at the end of the 20X1 reporting period
relating to the 24/7 Office contract (HK$4.75 million – HK$4.5 million = HK$250,000) is
expected to be utilised equally over a three-year period (i.e. HK$83,333 in 20X2, 20X3
and 20X4).
(b) Contract with 24/7 Office
From 1 March 20X2, Fine Print is subject to an onerous contract because the cost of
manufacturing ‘A1’ printers (HK$960/unit) now exceeds the wholesale price charged
by Fine Print (HK$950/unit). Under HKAS 37 Fine Print is to recognise a provision,
supported by the following analysis:
Criteria Application
Present obligation as a result of a The signing of the agreement is the obligating event,
past event as entering into the contract with 24/7 Office created
a contractual (legal) obligation to comply with the
terms of the agreement.
Probable outflow of resources Upon the contract becoming onerous on 1 March
embodying economic benefits to 20X2, an outflow of resources embodying economic
settle the obligation benefits is probable.
Reliable estimate can be made of the Because the agreement is non-cancellable, Fine
amount of the obligation Print is contractually obliged to fulfil the contract.
As of 31 December 20X2, one year remains on
the contract during which time it is estimated that
Fine Print will supply 800,000 ‘A1’ printers to 24/7
Office. The cost of manufacturing this quantity of
printers equals HK$768 million (HK$960 × 800,000),
while the expected benefits to be derived equals
HK$760 million (HK$950 × 800,000). The net cost of
fulfilling the contract is, therefore, HK$8 million.
Conclusion Fine Print will recognise a provision as of
31 December 20X2 at an amount of HK$8 million.
Prior to the contract becoming onerous, Fine Print would account for the contract in
accordance with HKFRS 15 Revenue from Contracts with Customers.
Warranty provision
For the 20X2 reporting period, Fine Print revises its best estimate of its warranty
obligations under the contract with 24/7 Office. Fine Print’s current best estimate is that
0.3% of current period sales will be returned by 24/7 Office customers for repair. As
such, the amount by which the warranty provision is increased for the 20X2 reporting
period is HK$2.565 million (HK$950 × 900,000 sales × 0.3%). The warranty provision is
raised by the following journal entry:
Debit Credit
HK$ HK$
Warranty costs 2,565,000
Warranty provision 2,565,000
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P rovisions , C ontingent L iabilities and Contingent Assets
The materials and labour costs of HK$2.25 million are charged against the warranty
provision as reflected in the following journal entry:
Debit Credit
HK$ HK$
Warranty provision 2,250,000
Cash 2,250,000
Assuming no other transactions are in relation to Fine Print’s warranty provision,
the note disclosure for the 20X2 financial statements is as follows:
Note XX: Provisions
Changes in the warranty provision for 20X2 were as follows:
Changes in provisions Warranty provision Onerous contract
HK$ HK$
31 December 20X1 510,000 –
Additions 2,565,000 8,000,000
Utilisation (2,380,000) 1 –
31 December 20X2 695,000 8,000,000
The provisions recognised in the statement of financial position as of 31 December
20X2 are expected to be utilised as follows:
Expected utilisation Warranty provision Onerous contract
of provisions
HK$ HK$
20X3 412,500 2 8,000,000
20X4 282,5003 –
Total 695,000 8,000,000
1
HK2.25 million + (HK$390,000/3 years).
2
(HK$390,000/3 years) + (HK$565,000/2 years).
3
(HK$565,000/2 years).
Warranty provision
Fine Print offers warranties on all printer sales, with warranty periods ranging from
12 months to three years. Its primary warranty commitments relate to a three-year
agreement with a major customer, where a rolling 12-month warranty period is offered.
Two of the three years of the agreement has expired. Fine Print uses prior experience
to estimate the expenditure to be incurred, and its timing, to satisfy the warranty
obligation, but both are subject to uncertainty.
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FINANCIAL REPORTING
Onerous contract
Fine Print is subject to an onerous contract with one of its customers, whereby the
expected costs of fulfilling the contract exceed the expected economic benefits to be
derived. As of 31 December 20X2, one year remains on the contract after which time
the contract will be terminated.
As evident from the note disclosure, utilisation of the warranty provision in
20X2 includes the amount of costs incurred to repair defective ‘A1’ printers as well
as the outflows relating to the other warranty commitments (i.e. HK$2.25 million +
HK$130,000 = HK$2.38 million).
As of 31 December 20X2, one year remains on the other warranty commitments of
Fine Print, and two years remain on the warranty commitments on the agreement with
the 24/7 Office. Even though one year remains on the contract with 24/7, a maximum
of two years remain on the warranty commitments because the 12-month warranty
period will continue to apply after the last day of the contract. That is, Fine Print will be
obliged to fulfil any warranty obligations for 12 months after contract-end should, for
example, a purchase occur on the last day of the contract.
The carrying amount of the warranty provision at the end of the 20X2 reporting
period relating to other warranty commitments (HK$130,000) is expected to be
utilised in 20X3. The carrying amount of the warranty provision at the end of the 20X2
reporting period relating to the 24/7 Office contract (HK$565,000 = HK$250,000 +
HK$2.565 million – HK$2.25 million) is expected to be utilised equally over a two-year
period (i.e. HK$282,500 in 20X3 and 20X4).
QUESTION 2
31 December 20X4
Decommissioning and restoration activities
HKOil is to recognise a provision for decommissioning and restoration costs estimated to be
incurred when the rig is dismantled. This assessment is reached based upon applying the
general recognition criteria of HKAS 37, as follows:
Criteria Application
Present obligation as a result of a past event The construction of the drilling rig creates a
contractual (legal) obligation to remove the rig
when extraction ceases. The construction of the
rig is, therefore, the obligating event creating
the present obligation.
Probable outflow of resources embodying An outflow of resources will probably be
economic benefits to settle the obligation required to settle the legal obligation. HKOil is
legally obliged to incur costs to remove the rig
when extraction ceases.
Reliable estimate can be made of the HKOil estimates it will cost HK$17.5 million
amount of the obligation (after taking account of risk and the time value
of money) to dismantle and remove the rig.
How HKOil accounts for the provision is influenced by its accounting treatment of the
drilling rig. The rig is to be recognised as property, plant and equipment. Under HKAS 16,
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P rovisions , C ontingent L iabilities and Contingent Assets
the rig is initially measured at cost, which includes an initial estimate of HK$17.5 million to
dismantle and remove the drilling rig. As such, the initial cost of the rig is HK$42.5 million.
The provision for decommissioning and restoration costs is raised as part of the
following journal entry:
Debit Credit
HK$ HK$
Property, plant and equipment 142,500,000
Cash 125,000,000
Provision for decommissioning and restoration 17,500,000
31 December 20X5
Decommissioning and restoration activities
Due to anticipated technological advancements supported by objective evidence, HKOil
decreases its best estimate of what it will cost to dismantle and remove the drilling rig by
HK$3.25 million (after taking account of risk and the time value of money). Under HK(IFRIC)
Int-1, how HKOil is to account for this revised best estimate depends upon the model used
to subsequently measure the drilling rig.
HKOil subsequently measures the drilling rig using the revaluation model. In
particular, for the 20X5 reporting period the drilling rig is depreciated by HK$2.85 million
(HK$142.5 million/50 years), giving rise to a carrying amount (prior to revaluation) of
HK$139.65 million (HK$142.5 million – HK$2.85 million). The drilling rig is subsequently
revalued to HK$145 million. The revaluation increment is recognised in other comprehensive
and increases the revaluation surplus by HK$5.35 million.
Under HK(IFRIC) Int-1, as HKOil measures the drilling rig using the revaluation model, the
decrease in provision due to the revised best estimate is recognised in other comprehensive
income and increases the revaluation surplus within equity. The change in provision is
recorded with the following journal entry:
Debit Credit
HK$ HK$
Provision for decommissioning and restoration 5,350,000
Other comprehensive income (revaluation surplus) 5,350,000
Petroleum spillage
As of 31 December 20X5, HKOil is subject to a contingent liability. A possible obligation exists
(i.e. to cleanup the petroleum spill) that arose from a past event (i.e. the spill itself) whose
existence will be confirmed only by the occurrence of an uncertain future event (namely, the
legislation being enacted as law). The clean-up for the petroleum spill does not satisfy the
requirements to be recognised as a provision because it is not a present obligation as the
result of an obligating event.
Whether HKOil will disclose information about the contingent liability in the notes
to its 20X5 financial statements depends upon the likelihood of an outflow to rectify the
1011
M11_c18.indd 1011 10/26/2022 4:30:51 PM
FINANCIAL REPORTING
environmental damage is remote or more likely than remote. Given the legislation was
enacted on 1 March 20X6 and is retroactive, it is reasonable for HKOil to assess (as of
31 December 20X5) that an outflow is more likely than remote.
The note disclosure for the 20X5 financial statements in relation to the contingent
liability is as follows:
Note XX: Contingent Liabilities
On 1 May 20X5, due to a ruptured pipeline on an HKOil drilling rig, a petroleum spill
occurred off the coast of Latma. At present, legislation is before the parliament of Latma
that, if enacted, will require HKOil to clean the spill at an estimated cost of HK$8 millon.
This amount, and timing of when any outflow will occur, is subject to uncertainty.
In addition, in accordance with HKAS 10 Events after the Reporting Period, the enactment
of the legislation constitutes a non-adjusting event after the reporting period. Under
HKAS 10, an entity is required to disclose information about material non-adjusting events
that occur after the end of the reporting period (in this case, 31 December 20X5) but before
the financial statements for that reporting period are authorised for issue. The information
to be disclosed is a description of the nature of the event and an estimate of the financial
effect of the event on the entity.
In this case, assuming the enactment of the legislation is material to HKOil is reasonable.
As such, in addition to the above note disclosure, HKOil would disclose, in the notes to
its 20X5 financial statements, a description of the nature of the event (e.g. On 1 March
20X6, the government of Latma enacted legislation that now requires HKOil to rehabilitate
environmental damage caused by a petroleum spill from an HKOil drilling rig that occurred
on 1 May 20X5) and an estimate of its financial effect (e.g. The management of HKOil
estimates it will cost HK$8 million to rectify the environmental damage caused by the
spillage).
QUESTION 3
(a) The closure of the manufacturing plant is one of the events under the definition of
restructuring. For the recognition of a provision for a restructuring, two principal
requirements to be met:
1. The entity has a detailed formal plan.
2. A valid expectation has been raised in those affected that the plan will be carried
HKAS out by starting to implement that plan or by announcing its main features to those
37.72 affected by it.
Even though FEL has decided on the closure of one of the manufacturing plants
without a public announcement to all its employees, no detailed plan exists with
sufficient details to give rise to valid expectations in other parties that the entity
will carry out the restructuring. The management decision to restructure taken on
1 December 20X4 is not relevant because FEL has not implemented the restructuring
plan or announced the main features of the restructuring plan to those affected with
sufficient detail. Accordingly, FEL should not make any provision as of 31 December
20X4 in respect of the restructuring plan.
1012
M11_c18.indd 1012 10/26/2022 4:30:51 PM
P rovisions , C ontingent L iabilities and Contingent Assets
The operational costs are not liabilities for restructuring at 31 December 20X4
as these expenditures are associated with the future conduct of the business.
These should be recognised on the same basis as if they arose independently of a
restructuring.
A restructuring provision does not include the cost of relocating continuing staff
pursuant to HKAS 37.81.
Dismantling a plant is a restructuring liability as it is entailed by the restructuring
and is not associated with the ongoing activities of FEL pursuant to HKAS 37.80.
In addition, the decision on the closure of the manufacturing plants is an
impairment indicator. The company should perform an impairment test and
any impairment loss should be recognised in profit or loss for the year ended
31 December 20X4.
(b) An onerous contract is defined as 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.
As the manufacturing cost per Product X (HK$22) is higher than the revenue per
Product X (HK$20), the supply contract is considered to be onerous and a provision
should be recognised. FEL should recognise a provision for the onerous contract equal
to the expected loss, i.e. HK$2 × 250,000 units of Product X (remaining quantities to be
delivered: (100,000 × 3) – 50,000) = HK$500,000.
1013
M11_c18.indd 1013 10/26/2022 4:30:51 PM
M11_c18.indd 1014 10/26/2022 4:30:51 PM
M11_c18.indd 1015 10/26/2022 4:30:51 PM
M11_c18.indd 1016 10/26/2022 4:30:51 PM
VOLUME 1 QUALIFICATION PROGRAMME QU
PR
VO
HKICPA Qualification: Pr
M
A Pathway to Success
The Qualification Programme (QP) of the Hong Kong Institute of CPAs (HKICPA) provides
a pathway for the development of world-class practicing accountants. The HKICPA is
the statutory body established by the Professional Accountants Ordinance responsible
for the professional training, development and regulation of certified public accountants
in Hong Kong. Members of the Institute are entitled to the description “certified public
accountant” and to the designation CPA.
Since 1973, the HKICPA (previously known as the Hong Kong Society of Accountants)
has worked to further the public interest by promoting efficient accounting practices in
Hong Kong. Through its efforts in promulgating financial reporting, auditing and ethical
standards, the Institute has helped safeguard Hong Kong’s leadership as an international
financial centre.
Our QP assures the quality of entry into the profession by providing accountants with
the knowledge base they need to meet future market needs. Successful participants
develop skills by completing training courses, passing examinations and acquiring
practical experience.
The QP consists of three levels. At the Associate Level, participants develop a solid
technical foundation. The aim of the Professional Level is to deepen technical capabilities.
The Capstone integrates knowledge, skills and experiences and applies them to business
problems.
The QP provides accountants with relevant and portable skills that enhance their
employability and opens the door to opportunities in Hong Kong and around the world.
The Hong Kong Institute of Certified Public Accountants
37th Floor, Wu Chung House, 213 Queen’s Road East, Wanchai, Hong Kong
Tel: (852) 2287 7228
Fax: (852) 2137 3293
www.hkicpa.org.hk
M11_c18.indd 1 10/26/2022 4:30:52 PM
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