ABC Limited manufactures and sells high-end fashion products. Its financial year-end is on 31 December. On 1 January 2019, ABC Limited entered into an agreement with XYZ Limited (‘XYZ’), an Italian ma

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ABC Limited manufactures and sells high-end fashion products. Its financial year-end is on 31 December. On 1 January 2019, ABC Limited entered into an agreement with XYZ Limited (‘XYZ’), an Italian manufacturer, to lease a production machine, namely ‘The Queen’, for a term of four years commencing 1 January 2019 and ending 31 December 2022 for exclusive use. The expected useful life of The Queen is five years. ABC Limited is the first to introduce the machine to the Hong Kong market. According to the contract with XYZ, ABC Limited must follow all the safety instructions in operating the machine and the machine can only be used in Hong Kong. Furthermore, XYZ is permitted to substitute The Queen at any time during the contract period if the substitute machine can meet the specifications and is of better performance than The Queen, as stipulated in the contract. Besides, XYZ must substitute the production machine if the machine is not working. XYZ would be responsible for all the costs involved in the substitution (e.g. delivery and installation of the new machine).

The annual lease payment is $800,000 payable at the end of each year. ABC Limited’s incremental borrowing rate on the commencement date is 5% per annum. Initial delivery cost and installation of The Queen amounting to HK$1,170,000 would be borne by ABC Limited.

Answer:

a Explain whether the contract is, or contains, a lease with reference to the Hong Kong financial reporting and accounting standards. (35 marks)

b Determine the amount of right-of-use asset and lease liability to be recognized on the inception date. (18 marks)

c Prepare a table showing the movement of lease liability throughout the lease period. (18 marks)

d Prepare journal entries (without narratives) to record the transactions in relation to the lease in 2019. (29 marks)

(Title Content Reference attachment)

ABC Limited manufactures and sells high-end fashion products. Its financial year-end is on 31 December. On 1 January 2019, ABC Limited entered into an agreement with XYZ Limited (‘XYZ’), an Italian ma
HKFRS 16 Leases (1) Identifying a lease At inception of a contract, an entity shall assess whether the contract contains a lease. Lease . A contract conveys the right to use of an identified asset for a period of time in exchange for consideration . *****Key issues in the assessment of a contract***** Right to control the use of asset An entity has the right to control an asset if it has the right to: (a) obtain substantially all economic benefits from use of the identified asset; AND (b) Direct the use of the identified asset Identified asset – Explicitly or implicitly specified in a contract – Without supplier substantive substitution rights during the period of use Supplier substantive substitution rights  Has the ability to substitute alternative assets, and  Would benefit economically from doing so A period of time – Lease term Right to obtain substantially all economic benefits from use – exclusive use of the asset throughout the period – obtain economic benefits directly or indirectly e.g. using, holding or sub -leasing the asset. – include its primary output and by -products Right to direct the use (customer can decide “what, when, where, whe ther” decisions) – can direct how and for what purpose the asset is used throughout the period of use; or – the relevant decisions about how and for what purpose the asset is used are predetermined and:  the customer has the right to operate the asset througho ut the period of use without the supplier chang ing those operating instructions; or  the customer designed the asset in a way that predetermines how and for what purpose the asset will be us ed (2) Lessee Accounting (Single Lease Accounting Model) Recognition At the commencement date, a lessee shall recognize a right -of -use asset and a lease liability Measurement Initial Measurement Subsequent Measurement Lease Liability – Present value of the lease payments that are not paid at that date Future lease payment  Fixed payments  Variable lease payments  Residual value guarantees  Exercise price of purchase option if reasonably certain to be exercised  payments of penalties for terminating the lease Lease liability is subsequently – reduce by the lease payments made – increase to reflect interest on the lease liability Right -of-use asset – At COST Cost components – Initial measurement of the lease liability – Lease payments made at or before the commencement date – Initial direct costs incurred by the lessee – Estimated dismantling and restoring costs at the end of lease term – LESS lease incentives – Cost Model (cost less acc. depreciation and any acc. impairment losses) Depreciation period of the ROU asset  shorter of lease term and useful life  over useful life of asset UNLESS certain that lessee will obtain the asset Other subsequent measurement model – HKAS 16 Revaluation Model – HKAS 40 Fair Value Model Accounting Treatment (I) Right -of-use asset and lease liability are recorded in statement of financial position Dr Right of Use Cr Lease Liability (II) Initial costs are added to the amount recognized as asset (III) Depreciation Dr Depreciation expense Cr Accumulated depreciation (IV) Record lease payment and interest Payment in advance (paid at the beginning of the year) Year Bal @ 1/1 Lease payment Lease Liability after lease payment Interest @ 10% Bal @ 31/12 2013 3,000,000 – 3,000,000 300,000 3,300,000 1/1 Dr Lease Liability Cr Cash 31/12 Dr interest expense Cr Lease Liability Payment in arrears (paid at the end of the year) Year Bal @ 1/1 Interest @ 10% Lease Liability after incurring interest Lease payment Bal @ 31/12 2013 3,000,000 300,000 3,300,000 1,000,000 2,300,000 31/12 Dr Interest expense Dr Lease liability Cr Cash Simplified accounting – Short term leases (less than 12 months) – Leases for assets of low value (less than US$5,000) (4) Lessor Accounting A lessor shall classify each of its leases as either an operating lease or a finance lease . Definition of Lease (Depends upon transfer of risks and rewards) Finance lease – transfers substantially all the risks and rewards incidental to ownership of an underlying asset Operating lease – does not transfer substantially all the risks and rewards incidental to ownership of an underlying asset Risk of ownership Rewards of ownership Possibility of losses from idle capacity Profitable operation over asset ’s life Possibility of losses from technological obsolescence Unrestricted access to asset Variation in return due to changing economic situation Gain in appreciation in value or realization of residual value Classification Criteria The lease will be classified as finance lease if it has ONE of the following characteristics: A. the lease transfers ownership of the underlying asset to the lessee by the end of the lease term ; B. the lessee has the option to purchase the underlying asset at a price that is expected to be sufficiently lower than the fair val ue at the date the option becomes exercisable for it to be reasonably certain , at the inception date, that the option will be exercised / ( Bargain Purchase Option ); C. the lease term is for the major part of the economic life of the underlying asset; D. at the inception date, the present value of the lease payments amounts to at least substantially all of the fair value of the underlying asset; E. the underlying asset is of such a specialised nature that only the lessee can use it without major modifications Les sor Accounting – Finance Lease – Measurement Initial Measurement – Recognize the amount due from lessee a receivable at an amount of net investment in the lease – Underlying asset should be derecognized – Initial direct costs (e.g. commissions, legal fees and other directly attributable costs) Net investment is present value of the sum of the following (fixed payments + variable lease payments + residual value guarantees + exercise price of purchase option if reasonably certain to be exercise d + penalties for terminating the lease + unguaranteed residual value ) Subsequent Measurement – Recognise finance income over the lease term reflecting a constant periodic rate of return on the lessor’s net investment in the lease – Record lease payments received in reducing both the principal and the unearned finance income Lessor Accounting – Operating Lease – Measurement Accounting Treatment – Recognize lease payments as income – Retain t he underlying asset remains in statement of financial position – Add initial direct costs of obtaining the lease to the carrying amount of asset – Depreciation should be provided
ABC Limited manufactures and sells high-end fashion products. Its financial year-end is on 31 December. On 1 January 2019, ABC Limited entered into an agreement with XYZ Limited (‘XYZ’), an Italian ma
HKAS 37 Provision, Contingent Liabilities and Contingent Asset Provision 1. Definitions Provision is a liability of uncertain timing and amount Liability is a present obligation of the entity arising from past event, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits 2. Provision VS Other Liabilities and Accruals Main difference : Uncertain about timing or amount of future expenditure 3. Recognition of Provision :KAS 37: A provision shall be r ecognized when: (a) An entity has a present obligation (legal or constructive) as a result of a past event (b) =t is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; AND (c) A reliable estimate can be made of the amount of the obligation =f ALL these conditions are NOT met, NO PROVISION recognized I. Present Obligation – Can be Legal or Constructive – Legal obligation : a duty to act in a certain way deriving from a contract, legislation, or some othe r operation of the law – Constructive obligation An obligation that derives from an entity’s actions where: ~ By an established pattern of past practice , published policies or a sufficiently specific current statement , the entity has indicated to other parties that it will accept certain responsibilities ; AND ~ As a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities. ** Court Case is Underway  Not clear whether there is present obligation  All available evidence should be considered to see whether there exists present obligation as a result of past event II. Probable Transfer of Economic Benefit – “Probable ”: Probability that the event will occur is greater than the probability that it will not (>50% ) 4. Measurement The amount recogni zed as a provision sh all be the best estimate of the expenditure required to settle the present obligation at the year end Best Estimate – Determined by the judgment of the management of the entity, supplemented by experience of similar transactions and reports from independent experts – Expected Values  Used when the provision being measured involved a large population of items Other Considerations in measuring provision – Risks and Uncertainties – Present Value – Future Events – Expected Disposal of Assets 5. Reimbursement – Some or all of the expenditure needed to settle a provision may be expected to be recovered from a third party through insurance contracts, indemnity clauses or supplier ’s warranties. – reimbursement shall be recogni zed when, and only when, it is virtually certain that reimbursement will be received if the entity settles the obligation – the reimbursemen t shall be treated as separate asset – the amount recognized for reimbursement shall not exceed the amount of provision – P/L – expense relating to provision may be presented the net amount recognized for reimbursement – General Accounting Treatment Recognize Pr ovision -> Reimbursement should be treated as a separate asset -> P/L: Present as net amount 6. Change in Provision – Provision should be reviewed at each reporting date and adjusted to reflect best estimates – No longer probable transfer economic benefits  Reverse Provision 7. Application of the Recognition and Measurement Rule I. Future Operating Losses – NO PROVISION recognized (No present obligation) – Cannot meet definition of liability and general recognition criteria for provision – Hust an indication of impairmen t II. Onerous Contract – An onerous contract is a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it . The unavoidable costs under a contract reflect the least net c ost of exiting from the contract, which is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfil it. – Present obligation under the contract shall be recognized + Probable outflow + Amount uncertain – Measured as Provision A common example would be leasehold property which is vacated before the lease term ends. For the remaining years of the lease, the cost of the property (future lease payments) exceeds the benefits derived from the property (likely to amount to nil if it is to be left vacant). =n this case, provision should be made for the future unavoidable lease payments as at the date on which the property is vacated. The provision is released as these payments are made in future years. III. Restructuring – A pr ogram that is planned and controlled by management and materially changes either:  The scope of a business undertaken by an entity; or  The manner in which that business is conducted. – E.g sale and termination of line of business, closure of business locations, changes in management structure, fundamental reorganization – Whether or not an entity has obligation at year end – A constructive obligation to restructure arises only when  The entity has a detailed formal plan for restructuring identifying  The business or part of business concerned  The principal location affected  Location, function and approximate number of employees who will be compensated for terminating their services  The expenditure that will be undertaken  When the plan is implemented; AND  The entity has raised a valid expectation in those affected that it will carry out the restructuring by starting to implement that plan or announcing its main features to those affecte d by it – Restructuring provision should include only the direct expenditures arising from the restructuring that are both:  Necessarily entailed by the restructuring  Not associated with the ongoing activities of the entity – BUT NOT =NCLUDE  Retraining or relocating continuing staff  Marketing  =nvestment in new systems and distribution networks  Future operating losses  Losses or gains on the expected disposal of assets Contingent Liability 1. A contingent liability is – A possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non -occurrence of one or more uncertain future events not wholly within the entity’s control ; OR – A present obligation that arises from past events but is not reco gni zed because:  =t is not probable that a transfer of economic benefits will be required to settle the obligation  Amount cannot be measured with sufficient reliability 2. Accounting Treatment Disclose in F.S Contingent Asset 1. Contingent asset is a possible as set that arises from past events and whose existence will be confirmed by the occurrence of one or more uncertain future events not wholly within the entity’s control. 2. Accounting Treatment Disclose in F.S Only when realization of related economic benefits is virtually certain -> Recognize as asset (A/R)

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