overview of ifrs and hkfrs - nelson cpa · years • paid a land premium to lease a land from the...

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© 2005-06 Nelson 1

Overview of IFRS and HKFRS1 June 2006

Nelson Lam Nelson Lam CFA FCCA FCPA(Practising)MBA MSc BBA CPA(US) ACA

© 2005-06 Nelson 2

Today’s Agenda

Summary of ConvergenceSummary of Convergence

Selected Major ChangesHKAS 17 LeasesHKAS 40 Investment PropertyHKAS 21 Effects of Changes in Foreign

Exchange RatesHKAS 39 Financial InstrumentsHKFRS 3 Business Combinations



Real Cases and ExamplesReal Cases

and Examples

Simple and Comprehensive

Simple and Comprehensive

Summary of ImpactSummary of Impact

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Summary of Convergence

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• Full convergence to International Financial Reporting Standards (IFRSs) and International Accounting Standards (IASs) in HK in 2005– Name change

• From Statements of Standard of Accounting Practice (SSAPs)• To Hong Kong Financial Reporting Standards (HKFRSs) and

Hong Kong Accounting Standards (HKASs)(same number, say IFRS 1 = HKFRS 1, IAS 12 = HKAS 12 ……)

– Standard contents change• Full alignment with IFRSs and IASs• Minor to major standard contents amendments• New standards

– Effective for the periods beginning on or after 1 January 2005– Early application is encouraged (in most cases)

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Hong Kong Financial Reporting Standards are:• Standards and Interpretations issued by the HK Institute of Certified

Public Accountants and comprise:– Hong Kong Financial Reporting Standards;– Hong Kong Accounting Standards; and– Interpretations.

• HKASs (Hong Kong Accounting Standards) – Totally 31 setsA. 9 sets of HKAS renamed from SSAPB. 9 sets of HKAS amended due to IASB’s Improvement ProjectC. 8 sets of HKAS aligned with IASD. 5 new sets of HKAS

• HKFRSs (Hong Kong Financial Reporting Standards) – Totally 7 setsE. 7 new sets of HKFRS (up to 30 May 2006)

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A. 9 sets of HKAS renamed from SSAP

HKAS 11 Construction contractsHKAS 12 Income taxesHKAS 14 Segment reportingHKAS 18 RevenueHKAS 19 Employee benefitsHKAS 20 Accounting for Government Grants and

Disclosure of Government AssistanceHKAS 34 Interim financial reportingHKAS 37 Provisions, Contingent Liabilities and

Contingent AssetsHKAS 41 Agriculture

⇐ SSAP 23⇐ SSAP 12⇐ SSAP 26⇐ SSAP 18⇐ SSAP 34⇐ SSAP 35

⇐ SSAP 25⇐ SSAP 28

⇐ SSAP 36

• Only name changed• Nothing new from old SSAPs• Only name changed• Nothing new from old SSAPs

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B. 9 Sets of HKAS amended due to IASB’s Improvement Project

HKAS 1 Presentation of financial statementsHKAS 2 InventoriesHKAS 8 Accounting Policies, Changes in Accounting

Estimates and ErrorsHKAS 10 Events after the Balance Sheet DateHKAS 16 Property, Plant and EquipmentHKAS 21 The Effects of Changes in Foreign Exchange

RatesHKAS 27 Consolidated and Separate Financial StatementsHKAS 28 Investments in AssociatesHKAS 33 Earnings Per Share

* HKAS 29 Financial Reporting in Hyperinflationary Economies (included in IASB’s Improvement Project but not yet issued in HK before, thus regarded as new in HK.)

• Refine some areas• Reduce some choices • Refine some areas• Reduce some choices

Numerous changesNumerous changes

Major changesMajor changes

Exemptions removedExemptions removed


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C. 8 Sets of HKAS Aligned with IAS

HKAS 7 Cash Flow StatementsHKAS 17 LeasesHKAS 23 Borrowing CostsHKAS 24 Related Party DisclosuresHKAS 31 Interests in Joint VenturesHKAS 36 Impairment of AssetsHKAS 38 Intangible AssetsHKAS 40 Investment Property

• Eliminate the differences with IASs, but ……

• Some have significant impact to small to large companies in HK

• Eliminate the differences with IASs, but ……

• Some have significant impact to small to large companies in HK

Major change in HKMajor change in HK






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D. 5 New Sets of HKAS

HKAS 26 Accounting and Reporting by Retirement Benefit Plans

HKAS 29 Financial Reporting in Hyperinflationary Economies

HKAS 30 Disclosures in the Financial Statements of Banks and Similar Financial Institutions (to be withdrawn)

HKAS 32 Financial Instruments: PresentationHKAS 39 Financial Instruments: Recognition and

Measurement

• New practices• Some have significant

impact on small to large companies in HK

• New practices• Some have significant

impact on small to large companies in HK



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E. 7 New Sets of HKFRS

HKFRS 1 First-time Adoption of Hong Kong Financial Reporting Standards

HKFRS 2 Share-based PaymentHKFRS 3 Business CombinationsHKFRS 4 Insurance ContractsHKFRS 5 Non-current Assets Held for Sale and Discontinued

OperationsHKFRS 6 Exploration for and Evaluation of Mineral ResourcesHKFRS 7 Financial Instruments: Disclosures

• All are new practices• Again …… some have

significant impact to small to large companies in HK

• All are new practices• Again …… some have

significant impact to small to large companies in HK

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Main Changes

HKFRSs set out• Recognition,• Measurement,• Presentation and

disclosure requirements

Main changes:• Changes in recognition

and measurement• Changes in presentation

and disclosure

• Less Choices• Towards

Fair Value Model

•• Less ChoicesLess Choices•• TowardsTowards

Fair Value ModelFair Value Model

• More and clearer presentation and disclosure

•• More and clearer More and clearer presentation and presentation and disclosuredisclosure

• Aim at enhancing the information for users’ decision making

•• Aim at enhancing Aim at enhancing the information the information for users’ for users’ decision makingdecision making

e.g. market value,value by appraisal ……

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Today’s Agenda






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Leases (HKAS 17)

Little change but significant impact

For Rent

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HKAS 17 is largely the same as SSAP 14, but has just been amended to align with IAS 17 (in respect of land and buildings) by

Leases – Little Change?

Little change but significant impact

2. Introducing several new paragraphs1. Deleting one sentence, and

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Leases – Deleting One Sentence

1. Deleting one sentence

Properties in HK are leasehold interest in land

• Not freehold land → Not a “purchase” but a “lease”• In the past, SSAP 14 had an exemption:

– deemed all the risks and rewards incident to ownership of the “leasehold property” were transferred

– therefore, such interest was accounted for as a “purchase” in accordance with

• SSAP 13 Accounting for investment properties or• SSAP 17 Property, plant and equipment, as appropriate• instead of SSAP 14

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Building only

Building only

Leases – Introducing New Paragraphs

New requirements with significant impact, mainly ……

Separate measurement

(of the land and buildings elements)

Separate measurement

(of the land and buildings elements)

Land onlyLand only

Land and Building

Land and Building

2. Introducing several new paragraphs1. Deleting one sentence

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Leases – Separate Measurement

• As before, lease classification is made– at the inception of the lease– leases of land and buildings are classified as operating or finance

leasesin the same way as leases of other assets

Building only

Building only

Land onlyLand only

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Operating Lease

Operating LeaseLand onlyLand only


Lease of landLease of land

• Land normally has an indefinite economic life• If title of leasehold land is not expected to pass to the lessee

⇒ Lessee normally does not receive substantially all of therisks and rewards incidental to the ownership

⇒ In which case the lease of land will be an operating lease• payment acquiring such leasehold represents

prepaid lease payments• amortised over the lease term in accordance with

the pattern of benefits provided

Leasehold landwithout title pass

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FinanceLease

FinanceLease

Title passed tothe lessee?

Yes

LandLand

No

BuildingBuilding

Operating Lease

Operating Lease

Lease of land and buildingsLease of land and buildings

If a lease contains land and buildingselements

2 elements are considered separately for lease classification

If title of both elements is expected to pass to the lessee

Both elements are classified as finance lease

Lease of landLease of land

If title of land or both elements is NOT expected to pass to the lessee

The land element alone is normally classified as an operating leaseThe building element is considered separately

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Lease of land and buildingsLease of land and buildings• To classify and account for a lease of land and buildings

• the minimum lease payments (including any lump-sum upfront payments) are allocated between the land and the buildings elements

• in proportion to the relative fair values of the leasehold interests in the land element and buildings element of the lease at the inception of the lease

• If the lease payments cannot be allocated reliably between the 2 elements• the entire lease is classified as a finance lease• unless it is clear that both elements are operating leases,

in which case the entire lease is classified as an operating lease• For a lease of land and building if the land is immaterial

• The lease may be treated as a single unit andclassified as finance or operating leases Building

onlyBuilding

only

Land onlyLand only

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FinanceLease

FinanceLease

Title passed tothe lessee?

Yes

LandLand

No

BuildingBuilding

Operating Lease

Operating Lease

Lease of land and buildingsLease of land and buildings

Can land and building be reliably separated?

No

No

Yes

Minimum lease payment allocated in proportion to the relative fair values of land and building elements

Minimum lease payment allocated in proportion to the relative fair values of land and building elements

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Leases – Separate MeasurementExampleExample

Entity A

• paid a land premium to lease a land from the HKSAR government for 50 years

• paid a land premium to lease a land from the HKSAR government for 50 years

• then, constructed a building on the land for own use

• then, constructed a building on the land for own use

10 years later, Entity B “acquired” the interest of the land and building from Entity A for own use

Assuming Entity B “acquired” the property at HK$20 million and at that time

A similar land has a fair value of $12MConstruction cost of a similar building is $4M

• HK$ 20M to be separated in proportion to the relative fair values of the land and building element at the inception of the lease, i.e. by HK$ 12M to HK$ 4M

• Then, the separate measurement will result in:Land = HK$15M ($20M ×$12M / $16M)Building = HK$ 5M ($20M × $ 4M / $16M)

• HK$ 20M to be separated in proportion to the relative fair values of the land and building element at the inception of the lease, i.e. by HK$ 12M to HK$ 4M

• Then, the separate measurement will result in:Land = HK$15M ($20M ×$12M / $16M)Building = HK$ 5M ($20M × $ 4M / $16M)

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“The early adoption of HKAS 17 has resulted in a change in accounting policy relating to leasehold land.”

“Leasehold land and buildings were previously carried at valuation less accumulated depreciation.”

“In accordance with the provisions of HKAS 17, a lease of land and building should be split into a lease of land and a lease of building in proportion to the relative fair values of the leasehold interests in the land element and the building element of the lease at the inception of the lease.”

“The lease premium for land is stated at cost and amortised over the period of the lease whereas the leasehold building is stated at valuation less accumulated depreciation.”

2004 Annual Report, HKEX

CaseCase

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“The early adoption of HKAS 17 has resulted in a change in accounting policy relating to leasehold land.”

“Leasehold land and buildings were previously carried at valuation less accumulated depreciation.”

“In accordance with the provisions of HKAS 17, a lease of land and building should be split into a lease of land and a lease of building in proportion to the relative fair values of the leasehold interests in the land element and the building element of the lease at the inception of the lease.”

“The lease premium for land is stated at cost and amortised over the period of the lease whereas the leasehold building is stated at valuation less accumulated depreciation.”

2004 Annual Report, HKEX

Effect of adopting HKAS 17 Leases Increase/(Decrease)Balance sheet as at 31 December 2004 HK$’000Fixed assets (170,100)Lease premium for land 95,218Deferred tax liabilities (19,139)Revaluation reserves (73,815)Retained earnings 18,072

Income statement for the year 2004Increase in premises expenses 548Decrease in depreciation (1,749)Increase in taxation 128

Effect of adopting HKAS 17 Leases Increase/(Decrease)Balance sheet as at 31 December 2004 HK$’000Fixed assets (170,100)Lease premium for land 95,218Deferred tax liabilities (19,139)Revaluation reserves (73,815)Retained earnings 18,072

Income statement for the year 2004Increase in premises expenses 548Decrease in depreciation (1,749)Increase in taxation 128


From valuation to cost (for land)• Non-current assets reduced by

HK$ 75 million

From valuation to cost (for land)• Non-current assets reduced by

HK$ 75 million

CaseCase

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Investment Property (HKAS 40)

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• Amended and clearer definition on an investment property

SSAP 13An investment property is an interest in land and/or buildings:a) in respect of which construction work and development have

been completed; andb) which is held for its investment potential, any rental income

being negotiated at arm’s lengthHKAS 40

Investment property is property (land or a building – or part of a building – or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciationor both, rather than for:a) use in the production or supply of goods or

services or for administrative purposes; orb) sale in the ordinary course of business

Definitions – Revised






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• Amended and clearer definition on an investment property






Definitions – Revised






How’s about property held by the lessee under an operating lease?

Examples of investment property under HKAS 40 include:• Property leased out under operating leases• Property held for long-term capital appreciation• Property held for a currently undetermined future use• Vacant property to be leased out under operating leases

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Definitions – To Operating Leases

• A property interest– that is held by a lessee under an operating lease

may be classified and accounted for asinvestment property if, and only if• the property would otherwise meet the definition of an

investment property and• the lessee uses the Fair Value Model

• This classification alternative is available on a property-by-property basis

• However, once this classification alternative is selected for one such property interest held under an operating lease, all propertiesclassified as investment property shall be accounted forusing the Fair Value Model

An entity has a choice

How’s about property held by the lessee under an operating lease?

Simple?Simple?

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Definitions – Owner-Occupied Property

• Introduce a new term, owner-occupied property– Defined as a property held (by the owner or by the lessee under a

finance lease) for use in the production or supply of goods or services or for administrative purposes

– In substance, a property under HKAS 16– Being one of the examples that is NOT an investment property

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Refer back to HKAS 16 for definition of property, plant and equipment• Property, plant and equipment are tangible items that:

a) are held for use in the production or supply of goods or services,for rental to others, or for administrative purposes; and

b) are expected to be used during more than one period.

Investment Property

Investment Property

Owner-occupied Property

Owner-occupied Property

Both for rental, how to distinguish?

Cash Flow Extent of Ancillary Services

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• One of the key indicators in determining the classification between investment property and owner-occupied property

Cash Flow

• held to earn rentals or for capital appreciation or both

• therefore, generates cash flows largely independently of the other assets held by an entity.

• the production or supply of goods or services (or the use of property for administrative purposes)

• generates cash flows that are attributable not only to property, but also to other assets used in the production or supply process

Investment Property

Investment Property

Owner-occupied property


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Investment Property

Investment Property



Ancillary services not significant

Ancillary services not significant

Significant ancillary services provided

Significant ancillary services provided


→ investment property

If owner-managed hotel was classified as investment property before 2005, it should be reclassified as• property, plant and equipment (HKAS 16) or• lease (HKAS 17)

• Significant impact on hotel group


Cash Flow Extent of Ancillary Services

• provided by an entity to the occupants of a property it holds is also considered

owner-occupied property e.g. a owner-managed hotel is not an

investment property

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• Before 2005, its hotel properties are classified as investment properties, which are stated at annual professional valuations at the balance sheet date

• It announced on 17 Dec. 2004 that its hotel properties “will no longer be accounted for as investment properties” from 2005

• It will adopt the following accounting policies retroactively:1. The underlying buildings and integral plant and machinery will be

stated at cost less accumulated depreciation and impairment2. The underlying freehold land will be stated at cost less impairment3. The underlying leasehold land will be stated at cost and subject to

annual operating lease rental charge (amortization of land cost)

ShangriShangri--La Asia Ltd.La Asia Ltd.(extracted from 2003 Annual Report and Announcement of 17 Dec. 2004)

• Owner-managed hotels cannot be classified as investment property

• They can be classified as property, plant and equipment (HKAS 16) and/or leases (HKAS 17)



CaseCase

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• 2004 Final Results Announcement of 31 Mar. 2005 further stated that, from 1 Jan. 2005:“Adoption of these new accounting policies will have the following significant consequences:a) The net book value of fixed assets, the overall provision for deferred

tax liabilities and the net asset value of the Group will be reducedb) The annual depreciation and lease rental charges will increase and

this will reduce the profit after tax attributable to the shareholders (“PAT”) and the earnings per share (“EPS”) of the Group.”

ShangriShangri--La Asia Ltd.La Asia Ltd.





Definitions – Owner-Occupied PropertyCaseCase

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• Let’s do some estimates (based on 2004 results announcement)

ShangriShangri--La Asia Ltd.La Asia Ltd.

Asset base shrunk

2003 2004US$’M US$M

Net assets 2,624 3,109If revaluation reserves eliminated

(due to reclassification of hotel properties) (650) (805)Adjusted net assets (by estimate only) 1,974 2,304


Equity (as announced in 2005) 1,847 2,337

CaseCase

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Interim Report 2005 stated that:

Six months ended 30 June (HK$’000) 2005 2004Note 3 to the interim report• Increase in depreciation arising from

reclassification of hotel properties and owner-occupied properties to PPE 73,245 50,767

Condensed consolidated income statement• Profit before tax (without fair value changes on

investment properties) 283,623 176,357

Percentage to the above profit 25.8% 28.8%

CaseCase

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Measurement after Recognition

Introduce Cost Model and choose either

Cost ModelCost Model


• HKAS 40 implicitly implies that the choice can only be elected on the first-time adoption of HKAS 40

• The model chosen should be applied to all investment properties, except for some identified exceptions.

and

• However, even Cost Model is adopted, HKAS 40 still requires all entities to determine the fair value of investment property ……• For disclosure purpose, the fair value of the investment property has to

be disclosed in notes to the financial statement!• In determining the fair value of investment property for both cost model

and fair value model⇒ an entity is only encouraged, but not required, to rely on a

professional valuer’s valuation

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Fair Value ModelFair Value ModelAfter initial recognition, an entity that chooses →• shall measure all of its investment property at

fair value, except in the cases that1. the fair value cannot be determined reliably, or2. the cost model is chosen for the investment property backing liabilities

that pay a return linked directly to the fair value of, or returns from specific assets including that investment property

• When a property interest held by a lessee under an operating lease is classified as an investment property⇒ the fair value model must be applied for all investment

properties• A gain or loss arising from a change in the fair value of

investment property shall be recognised in profit or loss for the period in which it arises

Depreciation?Tax Implication?

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HKAS 40• Uses fair value, instead of open market value

– but in substance, they are similar– not the same as SSAP 13, HKAS 40 only encourages, but not

requires, a profession valuation on a fair value



• Fair value is defined as the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction– Same definition used in other HKFRSs and HKASs– But HKAS 40 provides more explanations unique for a fair value of a property

• The fair value of investment property shall reflectmarket conditions at the balance sheet date

Depreciation?Tax Implication?

No depreciation required in HKAS 40

Not our concern this time!But be careful, good & bad …...

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Measurement after RecognitionCaseCase

For 6 months ended 2004 2005 ∆%HK$’M HK$’M

Turnover 3,987 4,385 ↑10%

Change in fair value ofinvestment properties - 1,015

Profit before tax 1,395 3,099 ↑120%

73% of 04 profit33% of 05 profit73% of 04 profit33% of 05 profit

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Interim Report 2005 clearly stated that:Interim Report 2005 clearly stated that:

CaseCase

• The directors consider it inappropriate for the company to adopt two particular aspects of the new/revised IFRSs as these would result in the financial statements, in the view of the directors, either:• not reflecting the commercial substance of the business or• being subject to significant potential short-term volatility, as

explained below …….

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Measurement after RecognitionCaseCase

• IAS 40 “Investment property” requires an assessment of the fair value of investment properties.

• The group intends to follow the same accounting treatment as adopted in 2004, which is to value such investment properties on an annual basis.

• Accordingly, the investment properties were not revalued at 30 June 2005, since the directors consider that such change of practice could introduce a significant element of short-term volatility into the income statement in respect of assets which are being held on a long-term basis by the group ……

• It is not practicable to estimate the financial effect of this non-compliance as no interim valuation of the properties has been conducted.

Interim Report 2005 clearly stated that:Interim Report 2005 clearly stated that:

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Effects of Changes in Foreign Exchange Rates(HKAS 21)

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Approach in HKAS 211. In preparing financial statements, each entity

determines its functional currency.

2. The entity translates foreign currency items or transactions into its functional currency and reports the effects of such translation.

3. The results and financial position of any individual entity (say subsidiary, associate or branches) within the reporting entity (say parent) whose functional currency differs from the presentation currency of the reporting entity are translated.

4. If the entity’s presentation currency differs from its functional currency, its results and financial position are also translated into the presentation currency.

Determine Functional Currency


Translate Foreign Currency Transactions

Translate Foreign Currency Transactions

Translate Foreign Operation or Whole Set

Translate Foreign Operation or Whole Set

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What is Foreign Currency?

• Foreign currency is a currency other than the functional currency of the entity.

• Functional currency is the currency of the primary economic environment in which the entity operates.

• Presentation currency is the currency in which the financial statements are presented.

1. In preparing financial statements, each entity determines its functional currency.



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Indicators to Determine

• Primary indicatorsa) the currency

i) that mainly influences sales prices for goods and services, andii) of the country whose competitive forces and regulations mainly

determine the sales price of its goods and services. b) the currency that mainly influences labour, material and other costs of

providing goods or service.• Other indicators in determining functional currency

a) the currency in which funds from financing activities (ie issuing debt and equity instruments) are generated.

b) the currency in which receipts from operating activities are usually retained.

Functional currency is the currency of the primary economic environment in which the entity operates.


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• When the above indicators are mixed and the functional currency is not obvious– management uses its judgement to determine the functional currency that

most faithfully represents the economic effects of the underlying transactions, events and conditions.

• An entity’s functional currency reflects the underlying transactions, events and conditions that are relevant to it– once determined, the functional currency is not changed unless there is a

change in those underlying transactions, events and conditions.• If the functional currency is the currency of a hyperinflationary economy, the

entity’s financial statements are restated in accordance with HKAS 29– An entity cannot avoid restatement in accordance with HKAS 29 by, for

example, adopting as its functional currency a currency other than the functional currency determined in accordance with HKAS 21 (such as the functional currency of its parent).



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• In its 2005 Interim Report, full set of HKFRS was adopted:– The functional currency of each of the consolidated entities has

been re-evaluated based on the guidance to the revised HKAS 21.• Accounting policy on functional and presentation currency:

– Items included in the financial statements of each of the Group entities are measured using the currency of the primary economic environment in which the entity operates (“the functional currency”).

– The consolidated financial statements are presented in HK dollars, which is the Company’s functional and presentation currency.

CaseCase

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• If Entity A, a HK incorporated company, reports its financial statements in HK$.

• However, its head office is located in HK but only serves for accounting purpose.

• All the other operation, trading and finance souring are located in UK and all the transactions are denominated in UK GBP.

• Which currency is the foreign currency of Entity A under HK SSAP 11 and HKAS 21?

ExampleExample

• Under HK SSAP 11• The reporting currency is HK$• The foreign currency is UK GBP

• Under HKAS 21• The functional currency is UK GBP• The foreign currency is HK$

• Under HK SSAP 11• The reporting currency is HK$• The foreign currency is UK GBP

• Under HKAS 21• The functional currency is UK GBP• The foreign currency is HK$

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Financial Instrument (HKAS 32 and 39)

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But I am sure, you may not forget ……

Pacific Century Insurance Holdings Ltd.

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Hang Hang Seng Seng BankBank (2004 Annual Report)

• On 1 January 2005, the Group has reclassified most of its Held-to-Maturity debt securities as Available-for-Sale securities.

• The change in fair value will cause volatility to the shareholders' equity.

Why reclassified most?Why reclassified most?

Why volatility to equity?Why volatility to equity?

CaseCase

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Summary of Changes

Scope Scope

Initial Recognition

Initial Recognition

MeasurementMeasurement

DerecognitionDerecognition

• Extended the scope to all contract to buy and sell of non-financial items that meet the scope.

• All financial instruments, including derivatives, are recognised in the balance sheet (on balance sheet).

• Except for strict conditions are fulfilled, all financial assets are measured at fair value

• Detailed derecognition rules are set out.

Definitions Definitions • Financial instruments, including derivatives,

are clearly defined.

© 2005-06 Nelson 54

Scope

Scope Scope • Extended the scope to all contract to buy and

sell of non-financial items that meet the scope.

How to capture all derivative contracts?How to capture all

derivative contracts?

Under HKAS 39, contracts to buy or sell a non-financial item can be mainly divided into 2 types:1. that can be settled

• net in cash or another financialinstrument, or

• by exchanging financial instruments

2. that were entered into and continue to be held• for the purpose of the receipt or delivery of a

non-financial item• in accordance with the entity’s expected

purchase, sale or usage requirements

Derivative contracts• as if financial instruments• within scope

Derivative contracts• as if financial instruments• within scope

Usual executory contracts• NOT within scopeUsual executory contracts• NOT within scope

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Definitions

Scope

Definitions Definitions • Financial instruments, including derivatives,

are clearly defined.

© 2005-06 Nelson 56

A financial instrument is any contract that gives rise to1. a financial asset of one entity, and2. a financial liability or equity instrument

of another equity

A financial instrument is any contract that gives rise to1. a financial asset of one entity, and2. a financial liability or equity instrument

of another equity

Definitions

Financial instrumentFinancial

instrument

Financial asset

Financial asset

Financial liability

Financial liability

Equity instrument

Equity instrumentor

of one entity

of another entity

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DerivativeDerivative

Definitions – Derivative

Equity instrument

Financial instrument

Financial asset

Financial liability or

⇒ is a financial instrument or other contract within the scope of HKAS 39 with all 3 of the following characteristics:a) its value changes in response to the change in a

specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable (sometimes called the ‘underlying’);

b) it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and

c) it is settled at a future date.

Value change based on an underlying


Little or no initial net investment


Settled ata future dateSettled at

a future date

Derivative

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Definitions – Derivative





Settled ata future dateSettled at

a future date

ExampleExample

Currency ratesCurrency Futures/Forward

Commodity pricesCommodity Futures/Forward

Currency ratesPurchased or Written Currency Option

Equity prices (equity of another entity)Equity Swap

Credit rating, credit index or credit priceCredit Swap

Total fair value of the reference asset and interest ratesTotal Return Swap

Interest ratesPurchased or Written Treasury Bond Option

Equity pricesEquity Forward

Underlying variableType of contract

Commodity pricesCommodity Swap

Currency ratesCurrency Swap (Foreign Exchange Swap)

Interest ratesInterest Rate Swap

DerivativeTypical example:

• Future and forward• Swap and options

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Initial Recognition

Definitions

Initial Recognition

Initial Recognition

• All financial instruments, including derivatives, are recognised in the balance sheet (on balance sheet).

Scope

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• An entity shall recognise financial instruments on its balance sheet when and only when the entity becomes a party to the contractual provisions of the instruments

Implies trade date accounting for all casesOnly a regular way purchase or sale (e.g. purchase of derivatives is not a regular way of purchase) can be accounted for by• either trade date accounting or settlement date accounting

Initial Recognition


instrument

Financial asset

Financial asset

Financial liability

Financial liability

Initial Recognition

Trade Date Accounting

Regular Way of purchase

or sale

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© 2005-06 Nelson 61

• When a financial asset or financial liability is recognised initially, an entity shall measurethe financial asset or a financial liability– at its fair value– plus transaction costs (except for those

classified at fair value through profit or loss)

Initial Recognition & Measurement


instrument

Financial asset

Financial asset

Financial liability

Financial liability

Initial MeasurementFair Value

Transaction Cost+

Initial Recognition

Trade Date Accounting

Regular Way of purchase

or sale

© 2005-06 Nelson 62

Fair value at Initial Recognition – Low Interest Loan• Entity A grants a 3-year loan of HK$50,000 to an important new

customer in 1 Jan. 2005– The interest rate on the loan is 4%– The current market lending rates for similar loans to customers with

a similar credit risk profile is 6%• Entity A believes that the future business to be generated with this new

customer will lead to a profitable lending relationship.

• On initial recognition, Entity A should recognise the carrying amount of the loan at the fair value of the payments that it will receive from the customer.

• How is the fair value of the payments at initial recognition calculated?

• On initial recognition, Entity A should recognise the carrying amount of the loan at the fair value of the payments that it will receive from the customer.

• How is the fair value of the payments at initial recognition calculated?

Initial Recognition & MeasurementExampleExample

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© 2005-06 Nelson 63

• Discounting the interest and principal repayments using the market rate of 6%, Entity A will recognise an originated loan of HK$47,327.

• The difference of HK$2,673 is expensed immediately– as the expectation about future lending relationships does not

qualify for recognition as an intangible asset.

• Discounting the interest and principal repayments using the market rate of 6%, Entity A will recognise an originated loan of HK$47,327.

• The difference of HK$2,673 is expensed immediately– as the expectation about future lending relationships does not

qualify for recognition as an intangible asset.

Initial Recognition & MeasurementExampleExample

$ 43,6601 / (1 + 6%)3$ 52,00031.12.2007

$ 1,8871 / (1 + 6%)1$ 50,000 x 4% = $ 2,00031.12.2005

$ 1,7801 / (1 + 6%)2$ 2,00031.12.2006

$ 47,327Fair value at initial recognition

Present valueDiscount factorCash inflow

© 2005-06 Nelson 64


Definitions

Initial Recognition

MeasurementMeasurement• Except for strict conditions are fulfilled, all

financial assets are measured at fair value

4-category classification will affect the subsequent measurementof financial assets (but not the initial measurement).


Scope

33

© 2005-06 Nelson 65

Measurement – Classification


instrument

Financial asset

Financial asset

Financial liability

Financial liability

Loans and receivablesLoans and receivables

FA at FV through P/L


HTM investments

HTM investments

AFS financial assets




© 2005-06 Nelson 66

A financial asset that meets either of the following 2 conditions.

a) It is classified as held for trading, if:i) it is acquired/incurred principally for the purpose

of selling or repurchasing it in the near term;ii) there is evidence of a recent actual pattern of short-

term profit-taking on it; oriii) a derivative

(except for a designated and effective hedging instrument)

b) Upon initial recognition it is designated by theentity as at fair value through profit or loss, except for investments in equity instruments that• do not have a quoted market price in

an active market, and• whose fair value cannot be reliably measured.

An entity has NO choice


Definition – for Financial Assets at Fair Value through P/LFA at FV through P/L



But …… new requirements for

2006

But …… new requirements for

2006

34

© 2005-06 Nelson 67

New requirements in 2006– The Fair Value Option (Jul. 2005)

Measurement – ClassificationDerivative?Held for trading (or

derivative)?



Upon initial recognition, designated at FA at FV

through P/L?

Yes

NoYes

Designated and effective hedging

instrument?No

Yes

Hedge Accounting

A Financial Asset

No

Yes

To be discussed later


through P/L?

• Restrict a company’s option in designating a financial asset (or financial liability) at FV through P/L

• Only allow to designate if conditions are met


through P/L (if allowed)?

3 Conditions to Designate3 Conditions to Designate

Financial asset

Financial asset

© 2005-06 Nelson 68


Effective from 1.1.2006: Upon initial recognition, an entity may designate a financial asset or financial liability as at fair value through profit or loss only:• when permitted by paragraph 11A of HKAS 39 (in

order to avoid separation of embedded derivative from hybrid contract), or

• when doing so results in more relevant information, because eitheri) it eliminates or significantly reduces a

measurement or recognition inconsistencyii) financial assets, financial liabilities or both is

managed and its performance is evaluated on a fair value basis

3 Conditions to Designate3 Conditions to Designate

1. Embedded Derivative Condition

1. Embedded Derivative Condition

2. Eliminates Inconsistency2. Eliminates Inconsistency

3. Managed on Fair Value Basis

3. Managed on Fair Value Basis

Definition – for Financial Assets at Fair Value through P/LFA at FV through P/L


Financial asset

Financial asset

35

© 2005-06 Nelson 69

• Those non-derivative financial assets that are designated as available for sale, or

• Those not classified into other categories• Implies

⇒ Except for those held for trading, all the remaining financial assets can be designated as AFS financial assets

⇒ Loans and receivables and HTM investments can also be initially designated as AFS financial assets




Measurement – ClassificationFA at FV

through P/LDefinition – for Available-for-sale financial assets

© 2005-06 Nelson 70

HTM investments

HTM investments

• Non-derivative financial assets with fixed or determinable payments and fixed maturity

• That the entity has the positive intention and ability to hold to maturity, other than– those initially designated as FA at FV through P/L– those designated as AFS financial assets– those that meet the definition of loans and receivables


through P/LDefinition

• A debt instrument with a variable interest rate can satisfy the criteria for a HTM investment.

• Equity instruments cannot be HTM investments either– because they have an indefinite life (such as ordinary shares) or– because the amounts the holder may receive can vary in a manner that is

not predetermined (such as for share options, warrants and similar rights).

AFS financial assets for Held-to-Maturity Investments

36

© 2005-06 Nelson 71

An entity shall not classify any financial assets as held to maturity– if the entity has,

• during the current financial year or• during the two preceding financial years,• sold or reclassified more than an insignificant amount of held-to-

maturity investments before maturity(more than insignificant in relation to the total amount of held-to-maturity investments)


The sales or reclassifications are exempted from the above Tainting Rule if they:– are so close to maturity or the financial asset’s call date (for example, less than 3

months before maturity) that changes in the market rate of interest would not have a significant effect on the financial asset’s fair value;

– occur after the entity has collected substantially all of the financial asset’s original principal through scheduled payments or prepayments; or

– are attributable to an isolated event that is beyond the entity's control, is non-recurring and could not have been reasonably anticipated by the entity.

The sales or reclassifications are exempted from the above Tainting Rule if they:– are so close to maturity or the financial asset’s call date (for example, less than 3

months before maturity) that changes in the market rate of interest would not have a significant effect on the financial asset’s fair value;

– occur after the entity has collected substantially all of the financial asset’s original principal through scheduled payments or prepayments; or

– are attributable to an isolated event that is beyond the entity's control, is non-recurring and could not have been reasonably anticipated by the entity.

HTM investments

HTM investments

Definitionfor Held-to-Maturity Investments

Subject toTainting Rule below


© 2005-06 Nelson 72

Measurement – ClassificationExampleExample

Sale of HTM investments• Entity A sells 1,000 bonds from its HTM portfolio with 5,000 bonds on

interim date of 2003 before the bonds will be matured in 2007.• Since Entity A wants to realise the appreciation in market price of the

bonds.

• The disposed bonds would be over an insignificant amount of the whole portfolio and it is not an exemption from Tainting Rule.

• The sale of part of the HTM portfolio “taints” that the entire portfolio and all remaining investments in the HTM category must be reclassified.

• Entity A will be prohibited from classifying any assets as HTM investments for 2 full financial years, until the year of 2006.

• The disposed bonds would be over an insignificant amount of the whole portfolio and it is not an exemption from Tainting Rule.

• The sale of part of the HTM portfolio “taints” that the entire portfolio and all remaining investments in the HTM category must be reclassified.

• Entity A will be prohibited from classifying any assets as HTM investments for 2 full financial years, until the year of 2006.

HTM investments

HTM investments

Definitionfor Held-to-Maturity Investments



37

© 2005-06 Nelson 73



• On 1 January 2005, the Group has reclassified most of its Held-to-Maturity debt securities as Available-for-Sale securities.

• The change in fair value will cause volatility to the shareholders' equity.

It explained why!It explained why!

CaseCase

© 2005-06 Nelson 74


• Non-derivative financial assets with fixed or determinable payments that arenot quoted in an active market, other than– those the entity intends to sell immediately or in the near term (which shall

be classified as held for trading)– those initially designated as FA at FV through P/L– those initially designated as AFS financial assets– those for which the holder may not recover substantially all of its the initial

investment, other than because of credit deterioration, which shall be classified as AFS financial assets

• An interest acquired in a pool of assets that are not loans or receivables is not a loan or receivable (for example, an interest in a mutual fund or a similar fund).

• Examples include:loan assets, trade receivables, rental deposits, deposits held by banks ……

Definition


through P/LHTM

investmentsAFS financial

assets

38

© 2005-06 Nelson 75

Measurement – ClassificationDerivative?Held for trading (or

derivative)?





Yes

NoYes


instrument?No

Yes

Hedge Accounting

NoDesignated as AFS

financial assets?Yes



A Financial Asset

No

Yes


Yes

HTM investments

HTM investments

Has positive intention and ability to hold to maturity and fulfils

tainting rule?

With fixed/determinable payments?

No

With fixed maturity?Yes

Yes

No

Yes

Yes

With quote inan active market?

No



May recover substantially all

initial investments

No

Yes

Yes

No

NoNo

© 2005-06 Nelson 76

MeasurementMeasurement after RecognitionClassification determine

Subsequent Measurement

at Fair Value

at Fair Value

at Amortised Cost

at Amortised Cost

Except for• investments in equity instruments that

• do not have a quoted market price in an active market, and

• whose fair value cannot be reliably measuredat Cost




HTM investments

HTM investments



39

© 2005-06 Nelson 77


No

No

Derivative?Held for trading (or derivative)?

FA at FVthrough P/L

FA at FVthrough P/L

HTM investments atamortised cost

HTM investments atamortised cost

Loans and receivables atamortised cost

Loans and receivables atamortised cost



Yes

NoYes

With fixed/determinable payments?


instrument?No

Yes

Hedge AccountingDesignated as AFS

financial assets?No

Yes

With fixed maturity?Yes

No

Has positive intention and ability to hold to maturity and fulfils

tainting rule?Yes


May recover substantially all

initial investments

Yes

No

Yes

Yes

No

No

AFS financial assets atfair value

AFS financial assets atfair value

A Financial Asset


Yes

No

No

Yes


Has a quote at active market or fair value can be reliably measured?

AFS financial assets at

cost

AFS financial assets at

cost

Yes

No Has a quote at active market or fair value can be reliably measured?

Yes

No

© 2005-06 Nelson 78


• Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.

Active market exists– A financial instrument is regarded as quoted in an active market if quoted

prices are readily and regularly available from an exchange and similar entities.

– The existence of published price quotations in an active market is the best evidence of fair value and when they exist they should be used to measure the financial asset (or financial liability)• For an asset held (or liability to be issued) Current bid price• For an asset to be acquired (liability held) Current ask price• If the current bid and asking prices not available Price of most

recent transaction

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© 2005-06 Nelson 79


• Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.

No active market– An entity establishes fair value by using a valuation technique– To establish what the transaction price would have been on the

measurement date in an arm’s length exchange motivated by normal business considerations

– Valuation techniques include• Using recent arm’s length market transactions between

knowledgeable, willing parties• Discounted cash flow analysis• Option pricing models

© 2005-06 Nelson 80


• In its 2005 Interim Report, full set of HKFRS was adopted and the report set out that:

– The fair values of quoted investments are based on current bid prices.

– If the market for a financial asset is not active (and for unlisted securities), the Group establishes fair value by using valuation techniques. These include• the use of recent arm’s length transactions,• reference to other instruments that are substantially the same,• discounted cash flow analysis, and• option pricing models refined to reflect the issuer’s specific

circumstances.

CaseCase

41

© 2005-06 Nelson 81

MeasurementMeasurement – Impairment

Impairment

At each balance sheet date• assess whether there is any

objective evidence that a financial asset (or group of financial assets) is impaired.

• Conditions must be fulfilledin recognising impairmentloss.

at Fair Value

at Fair Value

at Amortised Cost

at Amortised Cost

at Cost

Subsequent Measurement




HTM investments

HTM investments



© 2005-06 Nelson 82

Impairment (if there is objective evidence)

Measurement – Impairment

• Implicitly, no impairment review is needed as gain or loss on change in fair value is recognised in profit or loss

Outside the scope of HKAS 36


at Fair Value

Loans and receivables



HTM investments




• 2 conditions to effect impairment loss1. when a decline in its fair value has been

recognised directly in equity and2. there is objective evidence that it is impaired

• Then, the cumulative loss recognised directly in equity shall be• removed from equity and• recognised in profit or losseven the asset has not been derecognised.

at Fair Value

• Impairment loss is measured as the difference between• the carrying amount of the financial asset, and• the present value of estimated future cash

flows discounted at the current market rate of return for a similar financial asset.

at Cost

42

© 2005-06 Nelson 83


• The amount of impairment loss is measured as the difference between– the asset’s carrying amount, and– the present value of estimated future

cash flows (excluding future credit losses that have not been incurred) discounted at the financial asset’s original effective interest rate (i.e. the effective interest rate computed at initial recognition)

• The carrying amount of the asset shall be reduced either– directly or– through use of an allowance account.

• The amount of the loss shall be recognised in profit or loss.




at Fair Value

at Fair Value

at Amortised Cost

at Amortised Cost

at Cost



HTM investments

HTM investments


© 2005-06 Nelson 84


Sequence of Impairment Assessment• First assesses whether objective evidence

of impairment exists– individually for financial assets that are

individually significant, and– individually or collectively for financial assets

that are not individually significant.• If an entity determines that no objective

evidence of impairment exists for an individually assessed financial asset, whether significant or not

– it includes the asset in a group of financial assets with similar credit risk characteristics and collectively assesses them for impairment.

• Assets that are individually assessed for impairment and for which an impairment loss is or continues to be recognised are not included in a collective assessment of impairment.




at Fair Value

at Fair Value

at Amortised Cost

at Amortised Cost

at Cost



HTM investments

HTM investments


Implication?Implication?

43

© 2005-06 Nelson 85

Measurement – ImpairmentExampleExample

Impairment Based on Ageing Analysis• Entity A calculates impairment in the unsecured portion of loans and

receivables on the basis of a provision matrix– that specifies fixed provision rates for the number of days a loan has been

classified as non-performing as follows:• 0% if less than 90 days• 20% if 90-180 days• 50% if 181-365 days, and• 100% if more than 365 days

• Can the results be considered to be appropriate for the purpose of calculating the impairment loss on loans and receivables?

Not necessarily.• HKAS 39 requires impairment or bad debt losses to be calculated as

the difference between the asset’s carrying amount and the present value of estimated future cash flows discounted at the financialinstrument’s original effective interest rate.

Not necessarily.• HKAS 39 requires impairment or bad debt losses to be calculated as

the difference between the asset’s carrying amount and the present value of estimated future cash flows discounted at the financialinstrument’s original effective interest rate.

© 2005-06 Nelson 86


• The current accounting policy on provisions for bad and doubtfuldebts is set out in note 3(c) above.

• Note 3(c) states that:– It is the Group’s policy to make provisions for bad and doubtful debts

promptly where required and on a prudent and consistent basis.– There are two basic types of provisions, specific and general, each of

which is considered in terms of the charge and the amount outstanding.


Provisions for bad and doubtful debts

CaseCase

44

© 2005-06 Nelson 87


• On adoption of HKAS 39,– Impairment provisions for advances assessed individually are calculated

using a discounted cash flow analysis for the impaired advances.– Collective assessment of impairment for individually insignificant items

or items where no impairment has been identified on an individual basis is made using formula-based approaches or statistical methods.

– Impairment provisions for advances will be presented as individually assessed and collectively assessed instead of specific provisions and general provisions.

– There will be no significant change in the net charge for provisions to profit and loss account.


Provisions for bad and doubtful debts

CaseCase

© 2005-06 Nelson 88

MeasurementMeasurement – Summary




HTM investments

HTM investments



at Fair Value to P/L

at Fair Value to Equity

at Amortised Cost

at Amortised Cost

at Cost

SubsequentMeasurement Impairment

Not required

From Equity to P/L

To P/L

To P/L

To P/L

Reclassification

Not allowed

To HTM or AFS at Cost

To AFS at Fair Value

To AFS

Not described in HKAS 39; implicitly, not feasible

Reversal

N/A

Related objectively to an event for debt instrument only

Related objectively to an event

Related objectively to an event

45

Derecognition


instrument

Financial asset

Financial asset

Financial liability

Financial liability

Initial Recognition

Measurement

DerecognitionDerecognition • Detailed derecognition rules are set out.

Definitions

Scope

© 2005-06 Nelson 90


instrument

Financial asset

Financial asset

An entity shall derecognise a financial assetwhen, and only when:

a) the contractual rights to the cash flows from

the financial asset expire; or

b) it transfers the financial asset, and

the transfer qualifies for derecognition

General principles• If passing both Further Tests ⇒ derecognise the asset• If not passing Asset Transfer Test ⇒ not derecognise the asset• If passing the Asset Transfer Test, but

not passing Risk and Reward test ⇒ consider the entity’s control over the asset,and extent of continuing involvement

General principles• If passing both Further Tests ⇒ derecognise the asset• If not passing Asset Transfer Test ⇒ not derecognise the asset• If passing the Asset Transfer Test, but

not passing Risk and Reward test ⇒ consider the entity’s control over the asset,and extent of continuing involvement

Derecognition of Financial Assets

Direct derecognition

Further Test 1:Asset Transfer Test

Further Test 2:Risk and Reward Test

46

© 2005-06 Nelson 91


Has the entity transferred substantially all risks and rewards [Para. 20(a)]Has the entity transferred substantially all risks and rewards [Para. 20(a)]

Has the entity retained substantially all risks and rewards? [Para. 20(b)]Has the entity retained substantially all risks and rewards? [Para. 20(b)]

Derecognise the asset


Yes

Continue to recognise the asset


Yes



NoHas the entity retained control of the asset? [Para. 20(c)]Has the entity retained control of the asset? [Para. 20(c)]

No

No

Yes





Consolidate all subsidiaries (including any SPE) [Para. 15]Consolidate all subsidiaries (including any SPE) [Para. 15]

Determine whether the derecognition principles below are applied to a part or all of an asset (or group of similar assets) [Para. 16]

Determine whether the derecognition principles below are applied to a part or all of an asset (or group of similar assets) [Para. 16]

Has the entity transferred its rights to receivethe cash flows from the asset? [Para. 18(a)]

Has the entity transferred its rights to receivethe cash flows from the asset? [Para. 18(a)]

Have the rights to the cash flows from the asset expired? [Para. 17(a)]Have the rights to the cash flows from the asset expired? [Para. 17(a)]

Has the entity assumed an obligation to pay the cash flows from the asset that meets the conditions in paragraph 19? [Para. 18(b)]

Has the entity assumed an obligation to pay the cash flows from the asset that meets the conditions in paragraph 19? [Para. 18(b)]

Yes

No

No

No

Yes

Continue to recognise the assetto the extent of the entity’s continuing involvement

Continue to recognise the assetto the extent of the entity’s continuing involvement

Yes

© 2005-06 Nelson 92


Has the entity retained substantially all risks and rewards? [Para. 20(b)]Has the entity retained substantially all risks and rewards? [Para. 20(b)] Continue to recognise the asset


Yes

• If a transfer does not result in derecognitionbecause the entity has retained substantially all the risks and rewards of ownership of the transferred asset, the entity shall– continue to recognise the transferred asset in

its entirety– recognise a financial liability for the

consideration received– in subsequent periods, recognise

• any income on the transferred asset and• any expense incurred on the financial liability.

Recognise (create) a financial liability

Recognise (create) a financial liability

Consideration received

47

© 2005-06 Nelson 93

Derecognition of Financial AssetsExampleExample

For SMEs/SMPs ⇒ say Discounted Bills, Factored Trade ReceivablesFor larger entities ⇒ say Strip and Total return swap

Let’s analyse a bill discounted to bank⇒ At present, most entities derecognise bill receivable discounted to

bank and disclose it as contingent liability⇒ Is it appropriate under new derecognition criteria?

Let’s analyse a bill discounted to bank⇒ At present, most entities derecognise bill receivable discounted to

bank and disclose it as contingent liability⇒ Is it appropriate under new derecognition criteria?

The contractual rights to receive theasset’s cash flows are transferred

The contractual rights to receive theasset’s cash flows are transferred

If the debtor is default on the payment, the entity has to repaythe bank ⇒ risks are retained by the entity

If the debtor is default on the payment, the entity has to repaythe bank ⇒ risks are retained by the entity

Continue to recognise the bill receivables, and recognise a financial liability

© 2005-06 Nelson 94


• In its 2005 Interim Report, full set of HKFRS was adopted and the report set out that:– the Group’s discounted bills with recourse,

• which were previously treated as contingent liabilities,• have been accounted for as collateralized bank

advances prospectively on or after 1 January 2005,• as the financial asset derecognition conditions as

stipulated in HKAS 39 have not been fulfilled.

CaseCase

Total advances recognised: HK$ 822M

Current liabilities of that date: 7,578MNet current assets of that date: 1,229M

Total advances recognised: HK$ 822M

Current liabilities of that date: 7,578MNet current assets of that date: 1,229M

48

© 2005-06 Nelson 95

Business Combinations (HKFRS 3)

© 2005-06 Nelson 96

Summary of Changes in HKFRS 3

Method of accounting Method of accounting

Purchase method in all cases (prohibit uniting of interest or merger)

Purchase method in all cases (prohibit uniting of interest or merger)

Application of method

Application of method

Recognition of intangible assets, restructuring provisions and contingent liabilities amended

Recognition of intangible assets, restructuring provisions and contingent liabilities amended

Goodwill (and intangible asset)Goodwill (and

intangible asset) No amortisation and impairment testing only No amortisation and impairment testing only

Reassess and then recognise as a gain in the income statement

Reassess and then recognise as a gain in the income statement

Negative goodwill

Negative goodwill

49

© 2005-06 Nelson 97

Transition ProvisionsTransition Provisions

Objective of HKFRS 3

To specify• the financial reporting by an entity when it

undertakes a business combination

In particular, HKFRS 3 specifies that all business combinations should be accounted for by applying the purchase method

Therefore, the acquirer:a) recognises the acquiree’s identifiable assets,

liabilities and contingent liabilities at theirfair values at the acquisition date, and

b) recognises goodwill, which is subsequently tested for impairment rather than amortised

To specify• the financial reporting by an entity when it

undertakes a business combination

In particular, HKFRS 3 specifies that all business combinations should be accounted for by applying the purchase method

Therefore, the acquirer:a) recognises the acquiree’s identifiable assets,

liabilities and contingent liabilities at theirfair values at the acquisition date, and

b) recognises goodwill, which is subsequently tested for impairment rather than amortised

DisclosureDisclosure

Application of the method


Method of accountingMethod of accounting

ScopeScope

© 2005-06 Nelson 98

ScopeScope

Scope of HKFRS 3

Entities shall apply HKFRS 3 when accounting for all business combinations, except for business combinations:a) in which separate entities or businesses are brought together to form a

joint ventureb) involving entities or businesses under common controlc) involving two or more mutual entitiesd) in which separate entities or businesses are brought together to form a

reporting entity by contract alone without the obtaining of an ownership interest (for example, to form a dual listed corporation)

Common ControlCommon Control

Mutual EntitiesMutual Entities

All, but except for 4 types

All, but except for 4 types

Accounting Guideline 5 introduced on merger accounting for common control combinations

50

© 2005-06 Nelson 99

Method of Accounting

• All business combinations shall be accounted for by applying the purchase method.

• Uniting of interest (pooling of interest or merger) method is no longer allowed.

• Purchase method views a business combination from the perspective of the combining entity that is identified as the acquirer.

Method of accountingMethod of accounting

Scope

Purchase Method Only

Purchase Method Only

From an acquirer’s view

From an acquirer’s view

© 2005-06 Nelson 100

Application of the Method

Applying the purchase method involves the following steps:

Method of accounting

Scope


Application of the method (a) Identifying an acquirer(a) Identifying an acquirer

(b) Measuring the cost of the business combination(b) Measuring the cost of the business combination

(c) Allocating (b) to assets acquired and liabilities and contingent liabilities assumed at the acquisition date


(d) Initial accounting determined provisionally(d) Initial accounting determined provisionally

In addition, how if …..

Our focus todayOur focus today

51

© 2005-06 Nelson 101


At the acquisition date, the acquirer shall allocate the cost of a business combination by:



Cost of Business

Combination

• recognising the acquiree’s identifiable assets, liabilities and contingent liabilities that satisfy the recognition criteria at their fair values at that date – except for non-current assets (or disposal groups), that are

classified as held for sale in accordance with HKFRS 5, which shall be recognised at fair value less costs to sell

Identifiable assets,

liabilities and contingent liabilities

© 2005-06 Nelson 102


Any difference betweena) the cost of the business combination andb) the acquirer’s interest in the net fair value of the identifiable

assets, liabilities and contingent liabilities so recognised• shall be accounted for as goodwill or negative goodwill



Cost of Business

Combination

Goodwill



52

© 2005-06 Nelson 103




Recognition criteria:

1. Asset other than an intangible asset

2. Liability other than a contingent liability

• Probable that its future economic benefit will flow in• Its fair value can be measured reliably

• Probable that an outflow of resourceswith economic benefit will be requiredto settle the obligation

• Its fair value can be measured reliably

Aligned with HKAS 37Aligned with HKAS 37

Any special?Any special?3. Contingent liability or intangible asset

• Its fair value can be measured reliably



LiabilitiesLiabilities

Intangible assetsIntangible assets

Contingent liabilitiesContingent liabilities

Assume “Probable” fulfilled

© 2005-06 Nelson 104


• Under HKFRS 3– the acquirer recognises separately a contingent liability of the

acquiree as part of allocating the cost of a business combination only if• its fair value can be measured reliably.



– After their initial recognition, the acquirer shall measure contingent liabilities that are recognised separately under HKFRS 3 at the higher of:a) the amount that would be recognised in

accordance with HKAS 37, andb) the amount initially recognised less, when

appropriate, cumulative amortisation recognised in accordance with HKAS 18 Revenue.

Contingent liabilitiesContingent liabilities

NOT apply to contracts accounted for under HKAS 39

NOT apply to contracts accounted for under HKAS 39

53

© 2005-06 Nelson 105


Goodwill acquired in a business combination

• at the acquisition date– shall be recognised as an asset and– initially measured that goodwill at its cost

• after initial recognition– shall be measured at cost less any accumulated impairment losses– shall NOT be amortised– instead, shall be tested for impairment

• annually,• or more frequently if events or changes in

circumstances indicate that it might beimpaired in accordance with HKAS 36



Goodwill



© 2005-06 Nelson 106


• In 2004, as a result of the adoption of IFRS 3, IAS 36 and IAS 38 (equivalent to HKFRS 3, HKAS 36 and HKAS 38)– Depreciation reduced (profit increased) by HK$ 106 million– Trademarks increased by HK$ 86 million (resulted from

IAS 38)– Goodwill arising on the acquisition of Red Earth fully

impaired with a loss of HK$ 15 million

Esprit Holdings LimitedEsprit Holdings Limited

CaseCase

54

© 2005-06 Nelson 107


Negative goodwill

• No such name as “negative goodwill” now



• If there is such excess, the acquirer shall:a) reassess

• the identification and measurement of the acquiree’s identifiable assets, liabilities and contingent liabilities and

• the measurement of the cost of the combination; andb) after that reassessment,

• recognise immediately in profit or loss any such excess remaining (negative goodwill)

• Now termed as “excess of the acquirer’s interest in the net fair value of the acquiree’s identifiable assets, liabilities and contingent liabilities over the cost of a business combination”

• Now termed as “excess of the acquirer’s interest in the net fair value of the acquiree’s identifiable assets, liabilities and contingent liabilities over the cost of a business combination”

For our discussion purpose, Negative Goodwill is still usedFor our discussion purpose, Negative Goodwill is still used

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Today’s Agenda




Summary of ImpactSummary of Impact

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Summary of Impact

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Leases – Potential Impact

In the balance sheet• Prepaid lease payments reclassified and presented as

another non-current asset• Previous revaluation surplus on the land would be de-

recognised• Total assets would be reduced (if used revaluation

before), like HKEx

In the income statement• Depreciation would be affected

Remember its effect to leasehold property,like property “acquired” in HK …...

In the balance sheet• Prepaid lease payments reclassified and presented as

another non-current asset• Previous revaluation surplus on the land would be de-

recognised• Total assets would be reduced (if used revaluation

before), like HKEx

In the income statement• Depreciation would be affected

Remember its effect to leasehold property,like property “acquired” in HK …...

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Investment Property – Potential Impact

In the balance sheet• Significant impact on those had owner-occupied

property classified as investment properties before, say hotel group, asset base would be reduced, likeShangra Li

In the income statement• Profit would be significantly affected by the gain or

loss arising from changes in fair value of investment property

• More or less profit in 2005? In 2006?

In the balance sheet• Significant impact on those had owner-occupied

property classified as investment properties before, say hotel group, asset base would be reduced, likeShangra Li

In the income statement• Profit would be significantly affected by the gain or

loss arising from changes in fair value of investment property

• More or less profit in 2005? In 2006?

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Investment Property – Potential Impact

Interim Report 2005 stated that:

Six months ended 30 June (HK$’000) 2005 2004

Revenue 1,563,020 1,280,895Profit before tax 2,783,792 176,3571,478%1,478%

Once again, profit is even higher than the revenue

As fair value changes oninvestment properties included 2,500,169 -

Profit before tax without HKAS 40 (by estimate) 283,623 176,357

CaseCase

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Financial Instruments – Potential Impact

In the balance sheet• Financial instruments would be recognised• Assets and liabilities would be “gross-up” in some

cases, like Li & Fung• Off-balance sheet derivatives can no longer be “off”

again• Equity would also be affected

In the income statement• Profit would be affected by the changes in fair value

and would be volatile

In the balance sheet• Financial instruments would be recognised• Assets and liabilities would be “gross-up” in some

cases, like Li & Fung• Off-balance sheet derivatives can no longer be “off”

again• Equity would also be affected

In the income statement• Profit would be affected by the changes in fair value

and would be volatile

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Or more errors like ……

Pacific Century InsurancePacific Century Insurance• “This inadvertent error resulted in material misstatements of

the Group’s unaudited net profit ……”(24.1.2006 Announcement)

• On adoption of HKAS 39, all derivatives will be recognised as either assets or liabilities in the balance sheet at fair value and the change in fair value is recognised ……

• There will be higher volatility in income as a result of the stricter definition of a qualifying hedge.

• The change in fair value of derivatives designated as Cash Flow Hedges will create volatility in equity.


Financial Instruments – Potential ImpactCaseCase

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Business Combinations – Potential Impact

In the balance sheet• Depend on whether there are significant business

combination, and impairment losses• All business combinations within the scope of

HKFRS 3 should be accounted for as “acquisition” at fair value

• The balance of goodwill and intangible asset would be increased

In the income statement• Profit would be not be affected by goodwill or

intangible asset amortisation, but ……• would be affected by their impairment losses from

time to time, maybe significant

In the balance sheet• Depend on whether there are significant business

combination, and impairment losses• All business combinations within the scope of

HKFRS 3 should be accounted for as “acquisition” at fair value

• The balance of goodwill and intangible asset would be increased

In the income statement• Profit would be not be affected by goodwill or

intangible asset amortisation, but ……• would be affected by their impairment losses from

time to time, maybe significant

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Final RemarksCaseCase

Annual Report 2005 and Announcement

(440)0 Goodwill charge - amortisation

1,995824Net profit attributable to shareholders

0(1,128)Goodwill charge - impairment

2,4351,952Net profit attributable to shareholders before goodwill charges

2004(S$ million)

2005 (S$ million)

58% of net profit

Based on Singapore FRS 103 which is largely the same as IFRS 3

The reduced value-in-use resulted (or impairment loss incurred)

• from revised cash flow projections• on a lower profit base in 2005.

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Present and Future

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• Several amendments introduced in 2005 and 2006 and to be introduced in 2007

• Some critical amendments on table• Major capital markets have adopted or would adopt IFRS, including

– Australia– Europe– New Zealand– Hong Kong

• Committed to convergence with IFRS in phases– China– Japan– United States While FASB meets IASB ……While FASB meets IASB ……

A long road ahead ……

Present and Future

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Nelson Lam Nelson Lam [email protected]

Updated slides may be found in www.NelsonCPA.com.hk

© 2005-06 Nelson 120

Q&A SessionQ&A SessionQ&A Session

Nelson LamNelson [email protected]


Updated slides may be found in www.NelsonCPA.com.hk

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