Financial Reporting - commonly asked technical questions
The following are some of the more commonly asked questions based on technical enquiries received on accounting issues. The views expressed herein are developed by staff of the Hong Kong Institute of Certified Public Accountants (HKICPA). These are informal staff views and do not represent the official views of the HKICPA Council, standard setting committees, HKICPA management or other staff members of the HKICPA. The HKICPA and its staff do not accept any responsibility or liability in respect of the views expressed and any consequences that may arise from any person acting or refraining from action as a result of any materials below. Members of the HKICPA and other users of these materials should read the original text of the HKFRSs, HKFRS for Private Entities and Small and Medium-sized Entity Financial Reporting Framework and Financial Reporting Standard as found in the HKICPA Members’ Handbook for further reference and seek professional advice when considering the materials below. If you could not find your question, please kindly submit your enquiry to us (see link).
Question:
Entity A is a manufacturing company and is preparing its financial statements. How should Entity A present its analysis of operating expenses in the statement of profit or loss and other comprehensive income? Should it classify its expenses based on their function or their nature?
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Paragraph 99 of HKAS 1 Presentation of Financial Statements requires an entity to present an analysis of expenses recognised in profit or loss using a classification based on either their nature or their function within the entity, whichever provides information that is reliable and more relevant.
Paragraph 105 of HKAS 1 states that the choice between the function of expense method and the nature of expense method depends on historical and industry factors and the nature of the entity. Both methods provide an indication of those costs that might vary, directly or indirectly, with the level of sales or production of the entity. Because each method of presentation has merit for different types of entities, HKAS 1 requires management to select the presentation that is reliable and more relevant.
The analysis by function is sometimes referred to as the ‘cost of sales’ method, and is adopted by most of the manufacturing companies. Depending on the factors as stated in paragraph 105 of HKAS 1, Entity A, as a manufacturing company, may consider presenting its operating expenses based on their function.
Entity A should not generally show some expenses by nature and others by function as this may lead to understatement on some lines items. Entity A should consider the following requirements when selecting the presentation method and assessing whether to include additional line items:
- Presentation of additional line items in the statement of profit or loss and other comprehensive income is relevant to an understanding of the entity’s financial performance [HKAS 1.85].
- Presentation is neutral (free of bias) [Conceptual Framework for Financial Reporting paragraph 2.15].
- Additional disclosures of analysis by nature are made in the notes [HKAS 1.104]; and
- Such presentation is consistently applied and explained in the accounting policies [HKAS 8.13].
Fact pattern:
Entity A is a manufacturing company. In order to utilise its excess cash, Entity A purchases and redeems short-term investments frequently. These investments are recorded as financial assets at fair value through profit or loss in the statement of financial position. Total annual gross cash flows for purchase and redemption of these investments are HKD 10 million and HKD 12 million, respectively.
Question:
Should Entity A present its cash flows for the purchase and redemption of short-term investments on a gross or net basis in the statement of cash flows?
View:
Paragraph 21 of HKAS 7 Statement of Cash Flows requires an entity to report separately major classes of gross cash receipts and gross cash payments arising from investing and financing activities, except to the extent that cash flows described in paragraphs 22 and 24 of HKAS 7 are reported on a net basis.
Paragraph 22 of HKAS 7 provides an exception that cash flows arising from the following operating, investing or financing activities may be reported on a net basis:
(a) cash receipts and payments on behalf of customers when the cash flows reflect the activities of the customer rather than those of the entity; and
(b) cash receipts and payments for items in which the turnover is quick, the amounts are large, and the maturities are short.
One of the examples in paragraph 23A of HKAS 7 that referred to the situation in paragraph 22(b) is the purchase and sale of investments.
Applying to the above fact pattern, Entity A purchases and redeems short term investments frequently, and this could be an example of cash receipts and payments referred to in paragraphs 22(b) and 23A of HKAS 7 if the turnover of the investments is quick, the amounts involved are large, and the maturities of the investments are short. Entity A may present the related cash flows in net, but this is not required. This is an accounting policy choice as to whether to present the cash flows relating to the purchase and redemption of investments on a net or a gross basis. Entity A should apply its accounting policy consistently for similar transactions according to paragraph 13 of HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.
Question:
Paragraph 117 of HKAS 1 Presentation of Financial Statements requires an entity to disclose material accounting policy information. How should one determine whether accounting policy information is material?
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Paragraph 88C of HKFRS Practice Statement 2 Making Materiality Judgements explains that the materiality assessment for accounting policy information should follow the same guidance that applies to materiality assessments applicable to other information: by considering both qualitative and quantitative factors as described in paragraphs 44-55 of HKFRS Practice Statement 2. Diagram 2 of HKFRS Practice Statement 2 illustrates how an entity assesses whether accounting policy information is material and, therefore, shall be disclosed.
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Paragraph 117B of HKAS 1 provides examples of circumstances in which an entity is likely to consider accounting policy information to be material to its financial statements. The list is not exhaustive, but provides guidance on when an entity would normally consider accounting policy information to be material. These examples are
- the entity changed its accounting policy during the reporting period;
- the entity chose the accounting policy from one or more options permitted by HKFRSs;
- the accounting policy was developed in accordance with HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors in the absence of an HKFRS that specifically applies;
- the accounting policy relates to an area for which an entity is required to make significant judgements or assumptions in applying an accounting policy; or
- the accounting required for the transaction is complex.
In addition, paragraph 117C of HKAS 1 highlights that it is more useful to users of financial statements that an entity provides entity-specific information than standardised information, or information that only duplicates or summarises the requirements of the HKFRS Standards. HKFRS Practice Statement 2 provides the following two examples that illustrate making materiality judgements and:
- providing entity-specific information, while avoiding standardised (boilerplate) accounting policy information (Example S); and
- providing accounting policy information that only duplicates requirements in HKFRS Standards (Example T).
Question:
How to determine a lessee's incremental borrowing rate?
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Paragraph 26 of HKFRS 16 states that lease payments shall be discounted using the interest rate implicit in the lease, if that rate can be readily determined. If that rate cannot be readily determined, the lessee shall use the lessee’s incremental borrowing rate (IBR).
HKFRS 16 Appendix A defines lessee’s IBR as the rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment.
The definition specifies the factors (highlighted in bold) that are required to be reflected in calculating the lessee’s IBR. Paragraphs BC160-BC162 of the Basis for Conclusions accompanying HKFRS 16 provide further insight. In particular, paragraph BC161 explains that a lessee’s IBR takes into account the credit standing of the lessee, the length of the lease, the nature and quality of the collateral provided and the environment in which the transaction occurs. Paragraph BC162 states that depending on the nature of the underlying asset and the terms and conditions of the lease, a lessee may be able to refer to a rate that is readily observable as a starting point when determining its IBR for a lease (for example, the rate that a lessee has paid, or would pay, to borrow money to purchase the type of asset being leased, or the property yield when determining the discount rate to apply to property leases). Nonetheless, a lessee should adjust such observable rates as is needed to determine its IBR as defined in HKFRS 16.
The IFRS Interpretations Committee (IFRIC) issued an agenda decision (see link), which provides further explanation on the definition of a lessee’s IBR.
In the agenda decision, the IFRIC observed that the definition of a lessee’s IBR requires a lessee to determine its IBR for a particular lease considering the terms and conditions of the lease, and determine a rate that reflects the rate it would have to pay to borrow:
a. over a similar term to the lease term;
b. with a similar security to the security (collateral) in the lease;
c. the amount needed to obtain an asset of a similar value to the right-of-use asset arising from the lease; and
d. in a similar economic environment to that of the lease.
The definition of a lessee’s IBR in IFRS 16 does not explicitly require a lessee to determine its IBR to reflect the interest rate in a loan with a similar payment profile to the lease payments. Nonetheless, the IFRIC observed that, in applying judgement in determining a lessee’s IBR as defined in IFRS 16, it would be consistent with the International Accounting Standards Board’s objective when developing the definition of IBR for a lessee to refer as a starting point to a readily observable rate for a loan with a similar payment profile to that of the lease.
HKFRS 16 paragraphs 5-8 contain recognition exemptions for lessees, which allow a lessee to elect not to apply the requirements in HKFRS 16 paragraphs 22-49 to “short-term leases” and “leases for which the underlying asset is of low value”.
The following simplified example explains how these recognition exemptions may be applied.
Fact pattern:
A lessee enters into a lease arrangement to rent a car from 1 July 20X0 to 31 December 20X2, with no termination/renewal and purchase options. The monthly rental is HK$10,000. The lessee’s financial year-end is June. The lessee is currently preparing its financial statements for the year ended 30 June 20X2.
Questions:
i. The remaining lease term is less than 12 months (i.e. 1 July 20X2 to 31 December 20X2). Does the recognition exemption for short-term leases apply?
ii. The monthly rental is only HK$10,000, which the lessee considers is of low-value. Does the recognition exemption for low-value assets apply?
View:
Paragraph 5 of HKFRS 16 states that a lessee may elect not to apply the requirements in paragraphs 22-49 to:
(a) short-term leases (as defined in Appendix A of HKFRS 16 as a lease that, at the commencement date, has a lease term of 12 months or less. A lease that contains a purchase option is not a short-term lease); and
(b) leases for which the underlying asset is of low value (as described in paragraphs B3-B8 of HKFRS 16).
i. Short-term leases
Paragraphs BC87-BC97 of the Basis for Conclusions accompanying HKFRS 16 explain the considerations and decisions of the International Accounting Standards Board (IASB) during the development of IFRS 16 in relation to short-term leases. Particularly, paragraph BC93 states that the IASB decided to expand the short-term lease exemption by making the determination of duration of short-term leases consistent with the determination of lease term, thus considering the likelihood of extension options being exercised or termination options not being exercised.
In determining whether a lease is a short-term lease, with reference to the definition of a short-term lease, a lessee should perform an assessment at the commencement date of the lease to consider whether the lease has a lease term of 12 months or less. The assessment is not dependent on the remaining lease term.
Example 5 of the accompanying illustrative examples of HKFRS 16 is related to short-term leases.
Based on the fact pattern as described, although the remaining lease term is less than 12 months (i.e. 1 July 20X2 to 31 December 20X2), the commence date of the lease was 1 July 20X0 with a lease term of 30 months in total (i.e. 1 July 20X0 to 31 December 20X2), which is more than 12 months. Hence, the recognition exemption for short-term leases does not apply.
ii. Leases of low-value assets
Paragraphs B3-B8 of HKFRS 16 contain guidance on assessing leases for which the underlying asset is of low value. Paragraph B3 states a lessee shall assess the value of an underlying asset based on the value of the asset when it is new, regardless of the age of the asset being leased. Paragraph B4 states the assessment of whether an underlying asset of low value is performed on an absolute basis, and the assessment is not affected by the size, nature or circumstances of the lessee. Paragraph B6 states that a lease of an underlying asset does not qualify as a lease of a low-value asset if the nature of the asset is such that, when new, the asset is typically not of low value. For example, leases of cars would not qualify as leases of low-value assets because a new car would typically not be of low value. Paragraph B8 notes examples of low-value underlying assets can include tablet and personal computers, small items of office furniture and telephones.
Paragraphs BC98-BC104 of HKFRS 16 explain the IASB’s considerations during the development of IFRS 16 around leases of low-value assets. In particular, paragraph BC100 states that the IASB intended the exemption to apply to leases for which the underlying asset, when new, is of low value (such as leases of tablet and personal computers, small items of office furniture and telephones). The IASB had in mind leases of underlying assets with a value, when new, in the order of magnitude of US$5,000 or less. A lease will not qualify for the exemption if the nature of the underlying asset is such that, when new, its value is typically not low. The IASB also decided the outcome of the assessment of whether an underlying asset is of low value should not be affected by the size, nature, or circumstances of the lessee-i.e. the exemption is based on the value, when new, of the asset being leased; it is not based on the size or nature of the entity that leases the asset.
Example 11 of the accompanying illustrative examples of HKFRS 16 provides an example of the application of paragraphs B3-B8 of HKFRS 16 to leases of low-value assets.
Based on the fact pattern as described, the monthly lease payment is only HK$10,000. However, the recognition exemption for low-value assets is assessed based on the value of the underlying asset when it is new, and a lease of a car does not qualify as a lease of a low-value asset because a new car would normally not be of low-value. Hence, the recognition exemption for low-value assets does not apply.
Please refer to HKFRS 16, the accompanying Basis for Conclusions and illustrative examples for details of the requirements and illustrations (see link).
Answer:
- There are 3 sets of accounting standards (otherwise known as frameworks) issued by the Institute:
- HKFRS;
- HKFRS for PE; and
- SME-FRF & SME-FRS.
- All Hong Kong incorporated companies may choose to prepare their financial statements in accordance with HKFRS. Only eligible companies may choose to adopt the HKFRS for PE or the SME-FRF & SME-FRS. An entity should adopt a single financial reporting framework to prepare its financial statements.
- An entity applying the SME-FRF & SME-FRS should refer to the following requirements to develop its accounting policy if the Standard does not set out any specific requirements for an event or a transaction undertaken by the entity.
- Paragraph 1.2 of SME-FRS “… In the event that the SME-FRS does not cover an event or a transaction undertaken by an entity, management may consider the SME-FRF for guidance on developing an appropriate accounting policy, consistent with the historical cost convention, for that particular event or transaction.”
- Paragraph 2.1 of SME-FRS “Management should use its judgment in developing an accounting policy resulting in information that is relevant to the needs of users of the financial statements and is reliable in nature. Management should select and apply an entity’s accounting policies so that the financial statements comply with all the requirements of the SME-FRS and are consistent with the historical cost convention.”
- Paragraph 2.2 of SME-FRS “An entity should select and apply its accounting policies for a period consistently for similar transactions, other events and circumstances, unless the SME-FRS specifically requires or permits categorisation of items for which different policies may be appropriate.”
Answer:
- Footnote 2 of Section 11 of HKFRS for PE states that until HKAS 39 is superseded by HKFRS 9 Financial Instruments, an entity shall apply the version of HKAS 39 that is in effect at the entity’s reporting date. When HKAS 39 is superseded by HKFRS 9, an entity shall apply the version of HKAS 39 that applied immediately prior to HKFRS 9 superseding HKAS 39.
- An entity applying HKFRS for PE shall choose to apply either Sections 11 and 12 in full or the recognition and measurement requirements of HKAS 39 for its financial instruments when HKAS 39 was superseded by HKFRS 9.
- The archived version of HKAS 39 can be found here.