5 [P.T.O.3 Ethan, a public limited company, develops, operates and sells investment properties.
(a) Ethan focuses mainly on acquiring properties where it foresees growth potential, through rental income as well
as value appreciation. The acquisition of an investment property is usually realised through the acquisition of the
entity, which holds the property.
In Ethan’s consolidated financial statements, investment properties acquired through business combinations are
recognised at fair value, using a discounted cash flow model as approximation to fair value. There is currently an
active market for this type of property. The difference between the fair value of the investment property as
determined under the accounting policy, and the value of the investment property for tax purposes results in a
deferred tax liability.
Goodwill arising on business combinations is determined using the measurement principles for the investment
properties as outlined above. Goodwill is only considered impaired if and when the deferred tax liability is reduced
below the amount at which it was first recognised. This reduction can be caused both by a reduction in the value
of the real estate or a change in local tax regulations. As long as the deferred tax liability is equal to, or larger
than, the prior year, no impairment is charged to goodwill. Ethan explained its accounting treatment by confirming
that almost all of its goodwill is due to the deferred tax liability and that it is normal in the industry to account
for goodwill in this way.
Since 2008, Ethan has incurred substantial annual losses except for the year ended 31 May 2011, when it made
a small profit before tax. In year ended 31 May 2011, most of the profit consisted of income recognised on
revaluation of investment properties. Ethan had announced early in its financial year ended 31 May 2012 that
it anticipated substantial growth and profit. Later in the year, however, Ethan announced that the expected profit
would not be achieved and that, instead, a substantial loss would be incurred. Ethan had a history of reporting
considerable negative variances from its budgeted results. Ethan’s recognised deferred tax assets have been
increasing year-on-year despite the deferred tax liabilities recognised on business combinations. Ethan’s deferred
tax assets consist primarily of unused tax losses that can be carried forward which are unlikely to be offset against
anticipated future taxable profits. (11 marks)
(b) Ethan wishes to apply the fair value option rules of HKFRS 9 Financial Instruments to debt issued to finance its
investment properties. Ethan’s argument for applying the fair value option is based upon the fact that the
recognition of gains and losses on its investment properties and the related debt would otherwise be inconsistent.
Ethan argued that there is a specific financial correlation between the factors, such as interest rates, that form
the basis for determining the fair value of both Ethan’s investment properties and the related debt. (7 marks)
(c) Ethan has an operating subsidiary, which has in issue A and B shares, both of which have voting rights. Ethan
holds 70% of the A and B shares and the remainder are held by shareholders external to the group. The
subsidiary is obliged to pay an annual dividend of 5% on the B shares. The dividend payment is cumulative even
if the subsidiary does not have sufficient legally distributable profit at the time the payment is due.
In Ethan’s consolidated statement of financial position, the B shares of the subsidiary were accounted for in the
same way as equity instruments would be, with the B shares owned by external parties reported as a
non-controlling interest. (5 marks)
Required:
Discuss how the above transactions and events should be recorded in the consolidated financial statements of
Ethan.
Note: The mark allocation is shown against each of the three transactions above.
Professional marks will be awarded in question 3 for the quality of the discussion. (2 marks)
(25 marks)
