(d) HKAS 37 Provisions, Contingent Liabilities and Contingent Assets describes contingent liabilities in two ways. Firstly, as
reliably possible obligations whose existence will be confirmed only on the occurrence or non-occurrence of uncertain future
events outside the entity’s control, or secondly, as present obligations that are not recognised because: (a) it is not probable
that an outflow of economic benefits will be required to settle the obligation; or (b) the amount cannot be measured reliably.
In Chrissy’s financial statements contingent liabilities are not recognised but are disclosed and described in the notes to the
financial statements, including an estimate of their potential financial effect and uncertainties relating to the amount or timing
of any outflow, unless the possibility of settlement is remote.
However, in a business combination, a contingent liability is recognised if it meets the definition of a liability and if it can be
measured. The first type of contingent liability above under HKAS 37 is not recognised in a business combination. However,
the second type of contingency is recognised whether or not it is probable that an outflow of economic benefits takes place
but only if it can be measured reliably. This means William would recognise a liability of $4 million in the consolidated
accounts. Contingent liabilities are an exception to the recognition principle because of the reliable measurement criteria.
3 (a) The fair value model in HKAS 40 Investment Property defines fair value as the amount for which an asset could be exchanged
between knowledgeable, willing parties in an arm’s length transaction. Fair value should reflect market conditions at the date
of the statement of financial position. The standard gives a considerable amount of guidance on determining fair value; in
particular, that the best evidence of fair value is given by current prices on an active market for similar property in the same
location and condition and subject to similar lease and other constraints. Therefore investment properties are not being valued
in accordance with the best possible method. This means that goodwill recognised on the acquisition of an investment
property through a business combination of real estate investment companies is different as compared to what it should be
under HKFRS 3 Business Combination valuation principles. In reality, the fair value of both the property and the deferred tax
liability are reflected in the purchase price of the business combination. The difference between this purchase price and the
net assets recognised according to HKFRS 3, upon which deferred tax is based, is recognised as goodwill in the consolidated
statement of financial position.
16Ethan’s methods for determining whether goodwill is impaired, and the amount it is impaired by, are not in accordance with
HKAS 36 Impairment of Assets. The standard requires assets (or cash generating units (CGU) if not possible to conduct the
review on an asset by asset basis) to be stated at the lower of carrying amount and recoverable amount. The recoverable
amount is the higher of fair value less costs to sell and value in use. Fair value less costs to sell is a post-tax valuation taking
account of deferred taxes. According to HKAS 36, the deferred tax liability should be included in calculating the carrying
amount of the CGU, since the transaction price also includes the effect of the deferred tax and the purchaser assumes the tax
risk. Therefore, the impairment testing of goodwill should be based on recoverable amount, rather than on the relationship
between the goodwill and the deferred tax liability as assessed by Ethan.
Ethan should disclose both the methodology by which the recoverable amount of the CGU, and therefore goodwill, is
determined and the assumptions underlying that methodology under the requirements of HKAS 36. The standard requires
Ethan to state the basis on which recoverable amount has been determined and to disclose the key assumptions on which it
is based.
In accordance with HKAS 36, where impairment testing takes place, goodwill is allocated to each individual real estate
investment identified as a cash-generating unit (CGU). Periodically, but at least annually, the recoverable amount of the CGU
is compared with its carrying amount. If this comparison results in the carrying amount being greater than the recoverable
amount, the impairment is first allocated to the goodwill. Any further difference is subsequently allocated against the value of
the investment property.
The recognition of deferred tax assets on losses carried forward is not in accordance with HKAS 12 Income Taxes. Ethan is
not able to provide convincing evidence to ensure that Ethan would be able to generate sufficient taxable profits against which
the unused tax losses could be offset. Historically, Ethan’s activities have generated either significant losses or very minimal
profits; they have never produced large pre-tax profits. Therefore, in accordance with HKAS 12, there is a need to produce
convincing evidence from Ethan that it would be able to generate future taxable profits equivalent to the value of the deferred
tax asset recognised.
Any decision would be based mainly on the following:
– history of Ethan’s pre-tax profits;
– previously published budget expectations and realised results in the past;
– Ethan’s expectations for the next few years; and
– announcements of new contracts.
There have been substantial negative variances arising between Ethan’s budgeted and realised results. Also, Ethan has
announced that it would not achieve the expected profit, but rather would record a substantial loss. Additionally, there is no
indication that the losses were not of a type that could clearly be attributed to external events that might not be expected to
recur. Thus the deferred tax asset should not be recognised or at the very least reduced.
(b) Normally debt issued to finance Ethan’s investment properties would be accounted for using amortised cost model. However,
Ethan may apply the fair value option in HKFRS 9 Finanical Instruments as such application would eliminate or significantly
reduce a measurement or recognition inconsistency between the debt liabilities and the investment properties to which they
are related. The provision requires there to be a measurement or recognition inconsistency that would otherwise arise from
measuring assets or liabilities or recognising the gains and losses on them on different bases. The option is not restricted to
financial assets and financial liabilities. The HKICPA concludes that accounting mismatches may occur in a wide variety of
circumstances and that financial reporting is best served by providing entities with the opportunity of eliminating such
mismatches where that results in more relevant information. Ethan supported the application of the fair value option with the
argument that there is a specific financial correlation between the factors that form the basis of the measurement of the fair
value of the investment properties and the related debt. Particular importance was placed on the role played by interest rates,
although it is acknowledged that the value of investment properties will also depend, to some extent, on rent, location and
maintenance and other factors. For some investment properties, however, the value of the properties will be dependent on
the movement in interest rates.
Under HKFRS 9, entities with financial liabilities designated as FVTPL recognise changes in the fair value due to changes in
the liability’s credit risk directly in other comprehensive income (OCI). There is no subsequent recycling of the amounts in
OCI to profit or loss, but accumulated gains or losses may be transferred within equity. The movement in fair value due to
other factors would be recognised within profit or loss. However, if presenting the change in fair value attributable to the credit
risk of the liability in OCI would create or enlarge an accounting mismatch in profit or loss, all fair value movements are
recognised in profit or loss. An entity is required to determine whether an accounting mismatch is created when the financial
liability is first recognised, and this determination is not reassessed. The mismatch must arise due to an economic relationship
between the financial liability and the associated asset that results in the liability’s credit risk being offset by a change in the
fair value of the asset. Financial liabilities that are required to be measured at FVTPL (as distinct from those that the entity
has designated at FVTPL), including financial guarantees and loan commitments measured at FVTPL, have all fair value
movement recognised in profit or loss. HKFRS 9 retains the flexibility that existed in HKFRS 7 Financial Instruments:
Disclosures to determine the amount of fair value change that relates to changes in the credit risk of the liability.
