Answers to Exercise – Chapter 2

Answer – Exercise 1
(a) The four fundamental accounting concepts mentioned in HKAS 1 are:
(i) Going concern [1 mark]
The enterprise will continue in operational existence for the foreseeable future. [1
mark] This means that in particular the profit and loss account and balance sheet
assume no intention or necessity to liquidate or curtail significantly the scale of
operation. [1 mark]
(ii) Accruals [1 mark]
Revenue and costs are accrued and matched with one another, so far as their
relationship can be established or justifiably assumed. They are dealt with in the
profit and loss account of the period to which they relate; provided that where the
accrual concept is inconsistent with the “prudence” concept, the latter prevails. [1
mark] Revenue and costs are earned or incurred, not as money is received or
paid. [1 mark]
(iii) Consistency [1 mark]
There is consistency of accounting treatment of like items within each accounting
period [1 mark] and from one period to the next. [1 mark]
(iv) Prudence [1 mark]
Revenue and profits are recognised 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. [1 mark] Provision is made for all know liabilities
(expenses and losses) whether the amount of these is known with certainty or is at
a best estimate in the light of the information available. [1 mark]

(b) Accounting bases are the methods developed [1 mark] for applying fundamental
accounting concepts [1 mark] to financial transactions and items. [1 mark]

Examples of matters for which different accounting bases are recognised include:

(i) Depreciation of fixed assets

(ii) Treatment and amortisation of intangibles, such as research and development
expenditure, goodwill, patents and trademarks
(iii) Stocks and work-in-progress
(iv) Long-term contracts
(v) Leasing and rental transactions
(vi) Repairs and renewals

P. 1
 (vii) Consolidation policies
(viii) Property development transactions
(ix) Warranties for products or services

This list is not exhaustive, and may vary according to the nature of the operations
conducted.
[Any three items, each with 1 mark, total 3 marks]
(c) Accounting bases are designed to provide an orderly and consistently framework for
periodic reporting of a concern’s results and financial position. [1 mark] The
significance of accounting bases is that they provide limits to the area subject to the
exercise of judgement, and a check against arbitrary, excessive or unjustifiable
adjustments where no other objective yardstick is available.

The limitations of accounting bases are mainly on its regulatory powers.

(i) Accounting bases do not, and are not intended to, substitute for the exercise of
commercial judgement in the preparation of financial reports. [1 mark]
(ii) It is not possible to develop generalised rules for the exercise of judgement,
though practical working rules may be evolved on a pragmatic basis for limited
use in particular circumstances. [1 mark]

P. 2
Answer – Exercise 2
Sand Ltd
Income statement for the year ended 31 December 2005
$000
Revenues 12,090
Cost of sales (W1) (6,703)
Gross profit 5,387
Distribution costs (W2) (580)
Administrative expenses (W3) (1,563)
Finance costs (W4) (80)
Profit before tax 3,164
Income tax expense (100)
Profit for the year 3,064

Statement of comprehensive income for the year ended 31 December 2005

$000
Profit for the year 3,064
Other comprehensive income for the year:
Gain on revaluation of land (8,000,000 – 6,450,000) 1,550
Total comprehensive income for the year 4,614

P. 3
 Statement of financial position as at 31 December 2005
ASSETS $000
Non-current assets
Property, plant and equipment (W5) 8,810

Current assets
Inventory 800
Trade receivables (800,000 – 48,000) 752
Other current assets (prepayments, 12,000) 12
1,564
Total assets 10,374

EQUITY AND LIABILITIES

Equity attributable to owners of the company
Ordinary shares ($1 each) 1,000
Share premium 700
Retained profit 4,604
General reserve 150
Other components of equity 2,050
8,504
Non-current liabilities
8% Debentures, repayable on 31 March 2008 1,000

Current liabilities
Bank overdraft 200
Trade and other payables 470
(400,000 + Accruals (10,000 salaries + 40,000 interest + 20,000
audit fee)
Current tax payable 100
Dividends payable 100
870
Total liabilities 1,870
Total equity and liabilities 10,374

P. 4
 Statement of changes in equity for the year ended 31 December 2005
Share Share Retained General Revaluation Total
capital premium profit reserve reserve
$000 $000 $000 $000 $000 $000
At 1 Jan 2005 1,000 700 1,890 100 500 4,190
Changes in equity for
the year
Dividends (W6) (300) (300)
Total comprehensive
3,064 1,550 4,614
income for the year
Transfer to general
(50) 50 -
reserve
At 31 Dec 2005 1,000 700 4,604 150 2,050 8,504

Workings:
(W1) Cost of sales
$000 $000
Inventory, 1 Jan 2005 600
Add: Purchases 6,725
7,325
Less: Inventory, 31 Dec 2005 (800) 6,525
Bad debts 70
Increase in allowances for bad debts (48,000 – 40,000) 8
Directors’ remuneration 100
6,703

(W2) Distribution costs

Directors’ remuneration 60
Selling expenses 200
Discounts allowed 170
Depreciation on motor vehicles (600,000 x 25%) 150
580

(W3) Administrative expenses:

Discounts received (55)
Administrative salaries (400,000 + 10,000) 410
Depreciation on furniture and fittings (600,000 x 20%) 120
Audit fee 20

P. 5
Directors’ remuneration 140
Rent and rates (600,000 – 12,000) 588
Heating and lighting 340
1,563

(W4) Finance cost

Debenture interest 40
Debenture interest – second half-year (1,000,000 x 8% x
6/12) 40
80

(W5) Property, plant and equipment

Cost/valuation Accumulated Carrying amount
depreciation
$000 $000 $000
Freehold land 8,000 - 8,000
Furniture 600 240 360
Motor vehicles 800 350 450
9,400 590 8,810

Accumulated depreciation on:

- furniture and fittings = (600,000 – 480,000) + 120,000 = 240,000
- motor vehicles = (800,000 – 600,000) + 150,000 = 350,000

(W6) Dividend
= 200,000 + 1,000,000 x $0.10 = $300,000

P. 6