B301 Examination August 1996: Proposed Answers

Question 1 (6 marks)

(a) Ordinary shareholders:Ordinary shareholders normally have voting rights. They are effectively owners of the company and have the control over the company by electing the board of directors. They also have the right, to share profits after the payment of preference dividends, to shire in the distributions of residue assets if the company is liquidated, and to subscribe to additional shares if the company increases its share capital.

(b) Preference shareholders:Preference shareholders usually have no voting rights. They have preference over ordinary shareholders with respect to dividends and to distributions of assets in the event of liquidation. This means that preference shareholders must be paid in full before any payments are made to ordinary shareholders. The dividends on preference shares usually are fixed in amount. For preference shareholders with cumulative preference shares, the right to an unpaid dividend can be carried forward to later years, and these arrears of dividend must be paid before any dividend is paid to the ordinary shareholders.

(c) Debenture holders:Debenture holders are actually creditors of the company. Debenture holders have the right to be repaid their capital at maturity. Unlike dividends of ordinary and preference shareholders can only be payable if there are profits in the company, debenture holders can receive interest even the company sustains a loss during the years, i.e. debenture interest can be paid out of capital. Debenture holders also have the right to have their capital repaid in full under liquidation before any capital is returned to the shareholders, including both preference and ordinary shareholders.

Question 2 (6 marks)

(a) There are S standard headings required in a cash flow statement as stated in HKSSAP15:

• operating activities;
• returns on investments and servicing of finance;
• taxation;
• investing activities; and
• financing.

The objective of these standard headings is to ensure that cash flows arc reported in a form that highlights the significant components of cash flow and facilitates comparison of the cash flow performance of different businesses.

(b) Where the indirect method is adopted~ a reconciliation between the operating profit (normally profit before taxation and interest) reported in the profit and loss.(or income and expenditure) account and the net cash flow from operating activities should be given as a note to the cash flow statement. This reconciliation should disclose separately the movements in stocks, debtors and creditors related to operating activities and other differences between cash flows and profits. This reconciliation is optional where the direct method is adopted.

Question 3 (6 marks)

(a) Timing differences are differences between profits or losses as computed for tax purposes and results as stated in financial statements, which arise from the inclusion of items of income and expenditure in tax computations in periods different from those in which they are included in financial statements. 91liming differences originate in one period and are capable of reversal in one nr more subsequent periods.

(b) The different basis of arriving at profits for tax purposes derives from two main sources. Firstly, certain types of income are tax-free and certain types of expenditure are disallowable, giving rise to 'permanent differences' between taxable and accounting profits. Secondly, permanent differences also arise where there are tax allowances or charges with no corresponding amount in the financial statements.

(c) For a company having a relatively stable or growing investment in depreciable assets, dining differences arising from accelerated depreciation allowances are of a recurring nature and reversing differences are themselves offset, wholly or partially, or are exceeded, by new originating differences, thereby giving rise to continuing tax reductions or the indefinite postponement of any liability attributable to the tax benefits received. Thus this company can take tax relief year by year on capital expenditure. This tax relief may equal or exceed the additional tax which would otherwise have been payable in consequence of the reversal of the original timing differences through depreciation. Where for economic or other reasons a spasmodic or highly irregular pattern of depreciation allowances is forecast, a substantial period of time will need to be considered in attempting to assess whether a tax liability will crystallise. Where there is a declining availability of depreciation allowances, any originating timing differences will usually reverse, and deferred tax should be provided unless it is probable for other reasons that no tax liability will crystallise.

Question 4 (6 marks)

(a) The concept of 'prudence' as defined in HKSSAP I states that revenue and profits are not anticipated, but are recognised by inclusion in the profit and loss account only when realised in the form either of cash or of other assets the ultimate cash realisation of which can be assessed with reasonable certainty; provisionis made for all known liabilities (expenses and losses) whether the amount of these is known with certainty or is a best estimate in the light of the information available.

(b) The concept of 'prudence' stipulates different treatments for loss and gain. Particularly, losses should be recognised in financial statements whenever their amount can be ascertained or estimated. On the contrary, gains are normally not anticipated, but only recognised in financial statements when they are realised in the form either of cash or of other assets the ultimate cash realisation of which can be assessed with reasonable certainty. The spirit of this concept has been adopted in the standard accounting practice for reporting contingent gains and losses. A material contingent loss should be accrued in financial statements where it is probable that a future event will confirm a loss, which can be estimated with reasonable accuracy at the date on which the financial statements are approved by the board of directors. A material contingent loss not accrued should disclosed except where the possibility of loss is remote. Contingent gains should not be accrued in financial statements. A material contingent gain should be disclosed in financial statements only if it is probable that the gain will be realised.

Question 5 (6 marks)

(a) Stocks and work in progress comprise:

• goods or other assets purchased for resale;
• consumable stores;
• raw materials and components purchased for incorporation into products for sale;
• products and services in intermediate stages of completion;
• finished goods.

(b) The amount at which stocks and work in progress, other than long-term contract work in progress, is stated in periodic financial statements should be the total of the lower of cost and net realisable value of the separate items of stock and work in progress or of groups of similar items.

(c) The amount at which long-term contract work in progress is stated in periodic financial statements should be cost plus any attributable profit less any foreseeable losses and progress payments received and receivable. If, however, anticipated losses on individual contracts exceed cost incurred to date less progress payments received and receivable, such excesses should be shown separately as provisions.

Question 6 (6 marks)

(a) 'Property, plant and equipment' are tangible assets that:

• are held by an enterprise for use in the production or supply of goods or services, for rental to others, or for administrative purposes; and
• are expected tp ne used during more than one period

"Useful life" is either:

• the period of time over which an asset is expected to be used by the enterprise; or
• the number of production or similar units expected to be obtained from the assets by the enterprise.

(b) The depreciable amount of an item of property, plant and equipment should be allocated on a systematic basis over its estimated useful life. The depreication method used should reflect the pattern in which the asset's economic benefits are consumed by the enterprise. The depreciation charge for each period should be recognised as an expense unless it is included in the carrying amount of another asset.

Question 7 (21 marks)

(a) Bank ($'000)

(b) Debtos ledger ($'000)

(c) Creditors ledger ($'000)

(d) Accounts payable and accruals ($'000)

(e) Fixed assets schedule ($000)

(f).

Redone Company Umited

Trading and profit and loss account for the three months ended 31/12/95

Question 8 (23 marks)

a) Current account with branch recorded in head office's book

Current account with head office recorded in branch's book

b)

(c)

Home Appliances Limited

Balance Sheet as at 31 March 1995

Question 9 (26 marks)

(a) Trading results

(b) Calculation of Earnings per share

Note:

The basic earnings per share is calculated on earnings of $12,560,000 (1994: $10,520,000) and on the 4,540,000 ordinary shares in issue during the year (1994: 4,000,000 shares).

The fully diluted earnings per share is based on adjusted earnings of $12,900,000 after adding back interest net of profits tax on the 10% convertible unsecured loan stock. The remaining $4,000,000 of this stock was converted into 520,000 new ordinary shares of $4 par value on 31 Dece,ner 1995 making a total of 5,060,000 ordinary shares in issue in 1996. No figure for fully diluted earnings per share is shown for 1994 since the assmptions on which it was based no longer apply.

Remark:

Fully diluted earnings per ordinary share needs to be presented as the dilution is more than 5% of the basic earnings per ordinary share.