Chapter 12

Due Diligence Guidelines –

Financial

14. Forecasts and Projections

14.1 Standards

14.1.1 The listing applicant must determine in advance with its sponsor whether to include a profit forecast in a listing document. [Listing Rule 11.17 and Paragraph 34(2) of Part A of Appendix 1 to the Listing Rules]

14.1.2 Where a profit forecast appears in any listing document (other than one supporting a capitalisation issue), it must be clear, unambiguous and presented in an explicit manner and the principal assumptions, including commercial assumptions, upon which it is based, must be stated and such profit forecast must be prepared on a basis that is consistent with the accounting policies normally adopted by the listing applicant. [Listing Rule 11.17 and Paragraph 34(2) of Part A of Appendix 1 to the Listing Rules]

14.1.3 The accounting policies and calculations for the forecast must be reviewed and reported on by the reporting accountants and their report must be set out. The financial adviser or sponsor must report in addition that they have satisfied themselves that the forecast has been made by the directors after due and careful enquiry, and such report must be set out. [Listing Rule 11.17 and Paragraph 34(2) of Part A of Appendix 1 to the Listing Rules]

14.1.4 A profit forecast appearing in a listing document (other than one supporting a capitalisation issue) should normally cover a period which is coterminous with the listing applicant’s financial year end. If, exceptionally the profit forecast period ends at a half year-end the Exchange will require an undertaking from the listing applicant that the interim report for that half year will be audited. Profit forecast periods not ending on the financial year end or half year-end will not be permitted. [Listing Rule 11.18]

14.1.5 The assumptions upon which any profit forecast appearing in a listing document (other than one supporting a capitalisation issue) are based must provide useful information to investors to help them in forming a view as to the reasonableness and reliability of the forecast. Such assumptions should draw the investors’ attention to, and where possible quantify, those uncertain factors which could materially disturb the ultimate achievement of the forecast. The assumptions should be specific rather than general, definite rather than vague. All embracing assumptions and those relating to the general accuracy of the estimates made in the profit forecast should be avoided. Furthermore it will not normally be acceptable for assumptions to relate to matters which the directors, by virtue of their particular knowledge and experience in the business, are best able to take a view on or are able to exercise control over since such matters should be reflected directly in the profit forecast itself. [Listing Rule 11.19]

14.1.6 Where a profit forecast is included in a listing document, the accounting policies and calculations for the forecast must be examined and reported on by the reporting accountants and their report must be set out. The sponsor must report in addition that they have satisfied themselves that the forecast has been made by the directors after due and careful enquiry and such report must be set out. [Paragraph 34(2) of Part A of Appendix 1 to the Listing Rules]

14.1.7 Regarding the preparation of a listing document, a sponsor should assess the business performance, financial condition, development, prospects and any financial projection or profit forecast. [Paragraph 17.6(d)(vi) of the Code of Conduct]

14.1.8 Paragraph 13(b) of Practice Note 21 provides, among other things, that typical due diligence inquiries in respect of each new applicant and the preparation of its listing document and supporting information include assessing the new applicant’s profit forecast or estimate.

14.1.9 In relation to the deterioration of financial performance of the applicant, the Stock Exchange would expect disclosure of selected figures of updated key operating data (e.g. sales volume, average selling price, production volume, etc.) to be made in the prospectus. [Exchange Guidance Letter GL41-12]

14.2 Overview

14.2.1 (Other than in case of certain regulated financial institutions), the listing document will always contain a formal working capital statement covering a period of at least the next 12 months from the date of publication of the listing document.

14.2.2 Additionally, it has traditionally been common (though it is not mandatory) for Hong Kong listing documents to contain a profit forecast. (In more recent times there has been an increasingly common trend not to include a profit forecast).

14.2.3 See section 3 above (“Financial Content of the Listing Document”).

14.2.4 To support the working capital statement and any such profit forecast, it is normal that the listing applicant prepares a formal combined profit forecast and cash-flow memorandum.

14.2.5 This memorandum is typically based on, and contains projections extracted from, a projective model normally containing cash-flow projections covering a period at least 15 months beyond the date of the listing document. The memorandum should set out the principal assumptions and bases on which the projections have been made, and would normally include a sensitivity analysis. The memorandum (incorporating the underlying projections from which the numbers derive) is formally adopted by the listing applicant immediately prior to launch.

14.2.6 Focused due diligence is undertaken by the sponsor with respect to these important aspects of the listing document (and the listing applicant’s supporting memorandum).

14.2.7 The sponsor is required to opine formally on the working capital statement and any profit forecast:

(a) On the working capital statement, the sponsor must confirm to the Exchange in writing (based upon the listing applicant’s formal written confirmation to the sponsor, and other considerations noted at paragraph 3.4.5 above), that the sponsor is satisfied that the listing applicant’s confirmation has been given after due and careful enquiry by the listing applicant and that the persons or institutions providing finance have stated in writing that the relevant financing facilities exist; and

(b) On any profit forecast, the sponsor must report that it has satisfied itself that the forecast has been made by the directors after due and careful enquiry, and such report must be set out in the listing document.

14.2.8 Any “loss” forecast is treated on the same basis as a profit forecast.

14.3 Guidance

14.3.1 Forecasts are judgemental, rather than definitive, opinions notwithstanding that they are expressed in numerical form. As a result, forecasts are not capable of confirmation in the same way as financial statements which relate to completed accounting periods. Nevertheless, forecasts should be formally adopted by the listing applicant’s board of directors, including or together with the supporting memorandum described in this section.

14.3.2 The process for creating and determining a forecast varies from case to case according to the nature of the listing applicant and its business, organisation and internal procedures. Therefore there is no standardised process for review of the forecast. It is an iterative process and detailed practice will vary from sponsor to sponsor.

14.3.3 However, by the time the review is concluded, the steps described below under “Sponsor’s Review Process” should normally have been undertaken.

14.4 Sponsor’s Review Process

14.4.1 The primary objective of the sponsor’s review of the forecast is to achieve sufficient understanding and confidence in the reliability of the forecast to permit conclusions by the sponsor that:

(a) The judgments involved in the forecast have been soundly made, and the forecast reliably compiled, by the listing applicant’s directors;

(b) The forecast is satisfactory for purposes of the listing document; and

(c) The sponsor is willing and able to report as required in the listing document.

14.4.2 Preliminary Review

(a) The process of overall familiarisation begins with preliminary business and financial due diligence (see section 4 above “Financial Review Process”).

(b) In context of forecasts and projections, the most significant areas of focus are drivers of revenues and profitability.

(c) The sponsor should also consider at an early stage if there may be any accounting rules or practices which significantly impact profits (for example, any fair value adjustments or other non-cash items).

14.4.3 Examine History of Reliability of Internal Budgeting and Forecasting

(a) The sponsor should consider historic consistency of performance compared to budget.

(b) This question can be considered in the course of management discussions, and together with the sponsor’s own documentation review.

(c) In particular the sponsor should consider what evidence is available as to historic reliability of past budgets.

(d) This question should also be discussed with the Reporting Accountant (see below “Reporting Accountant Input to the Review Process”).

(e) Overall, the sponsor should seek to assess whether the listing applicant’s forecast exercise is a normal / well rehearsed process, or something less familiar.

14.4.4 Line-by-Line Review

(a) The sponsor should request copies of the listing applicant’s supporting profit forecast and cash-flow memorandum.

(b) At an appropriate stage the sponsor should discuss the forecast and projections in detail with the listing applicant’s management (most particularly, the Chief Financial Officer and any other senior finance staff who have been involved in preparing the forecasts).

(c) The sponsor should aim to understand each line item.

14.4.5 Comparison with Results to Date

(a) At the time the listing document is issued, the sponsor will know how far into the accounting period the forecast is being made.

(b) The sponsor should be in a position to consider what reliable evidence exists of results to date. See also section 11 above (“Changes Subsequent to Latest Balance Sheet Date”).

(c) These factors are relevant to overall certainty and in considering what “buffer” may be suitable (see below).

14.4.6 Review of Assumptions

(a) It is important to understand and obtain a record of the assumptions underlying the forecast and projections.

(b) The sponsor should seek to evaluate:

(i) what are the most significant drivers / dependencies (e.g., sales);

(ii) whether there is a single dominant factor;

(iii) any significant accounting drivers (e.g., fair value adjustments or other material non-cash items);

(iv) any non-ordinary course (or one-off) assumptions;

(v) how much of the forecast is dependent on anything new in (or projected for) the business; and

(vi) (if applicable) the impact of any IPO proceeds.

(c) The sponsor should consider and discuss with management the potential impact of material extrinsic factors such as general economic conditions, commodity or materials prices, exchange rates, tax rates, regulation and political risk.

(d) The assumptions should be evaluated for predictability and risk based on materiality and relative degrees of certainty or uncertainty.

(e) This evaluation is normally a judgemental exercise of a qualitative nature (rather than anything empirically measurable).

14.4.7 Sensitivity Analysis

(a) A sensitivity analysis should always be performed on key line items (or components thereof) which may be subject to material variation.

(b) For example, a calculation might be made to demonstrate the impact of a shortfall of (say) 5% or 10% in sales.

(c) The sensitivity analysis should normally form part of the listing applicant’s combined profit forecast and cash-flow memorandum.

14.4.8 Discussion with Reporting Accountant

(a) The sponsor should seek to arrange meeting(s) with the Reporting Accountant to discuss the listing applicant’s forecasts and projections, and the supportive profit forecast and cash-flow memorandum.

(b) See further below under “Reporting Accountant Input to the Review Process”.

14.4.9 Finance counterparties

(a) As indicated below (see “Reporting Accountant Input to the Review Process”), part of the work performed by the Reporting Accountant in evaluating the projections is to obtain evidence and satisfy itself that the persons or institutions providing finance have stated in writing that the relevant financing facilities exist.

(b) Nevertheless, in cases where the listing applicant’s liquidity and working capital are significantly dependent on financing facilities, the sponsor should arrange interviews with the relevant banks or other finance providers.

(c) It is not essential (and will rarely be the case) that the listing applicant has committed financing facilities covering all funding requirements for future plans and projects referred to in the listing document. However, it will normally be important to obtain evidence that funding is committed (but not necessarily drawn down in advance) to the extent it is material to the cash flows for the period covered by the formal working capital statement in the listing document.

14.4.10 Buffer

(a) A listing applicant will never normally set its published forecast at the maximum level it might achieve.

(b) This is because a published forecast requires to be prudently made and the expectation should always be that the listing applicant will exceed the forecast.

(c) Accordingly the forecast will normally contain an element of “buffer”.

(d) Factors affecting the level of “buffer” will typically include:

(i) Prior experience of the listing applicant in forecasting and budgeting.

(ii) Level of uncertainty in significant underlying assumptions.

(iii) The length of the forecast relative to the amount of the forecast period for which results are already known or are capable of reliable estimation.

(iv) Level of current year performance compared to budget.

14.5 Formal Process

14.5.1 As indicated, to support the working capital statement and any profit forecast, it is normal that the listing applicant prepares a formal combined profit forecast and cash-flow memorandum.

14.5.2 This memorandum (incorporating the underlying projections from which the numbers derive) should be formally adopted by the listing applicant immediately prior to launch.

14.5.3 Although it is an applicant-prepared output / document (and the sole responsibility of the listing applicant’s directors), it is important that the memorandum is carefully considered by the Reporting Accountant.

14.5.4 The Reporting Accountant plays a key role in ensuring that the projections are prepared on a basis that is consistent with the accounting policies adopted in the listing applicant’s audited financial statements.

14.5.5 In connection with any profit forecast, the Reporting Accountant is required to report formally (in a letter from the Reporting Accountant which is published within the listing document) on the accounting policies adopted and calculations made in arriving at the profit forecast.

14.5.6 In practice, even though the Reporting Accountant’s report is restricted to matters of accounting policies and compilation, (i) the Reporting Accountant will not be prepared to issue such a report (without express comment in the report) unless it has also considered the underlying assumptions and satisfied itself that there are no unrealistic assumptions or important omissions and (ii) careful consideration of the directors’ projections is required for the Reporting Accountant’s private report in relation to the working capital statement (see immediately below).

14.5.7 Accordingly, sponsors place significant reliance on the Reporting Accountant with respect to accounting aspects of the forecast.

14.5.8 In addition to the published report on any profit forecast, the Reporting Accountant should also be engaged by the listing applicant to report privately with respect to the working capital statement. See section 3.7 above (“Financial Content Of The Listing Document – Guidance On Profit Forecast and Working Capital Statement, and Recommended Steps”).

14.5.9 Part of the work performed by the Reporting Accountant in evaluating the projections is to obtain evidence and satisfy itself that the persons or institutions providing finance have stated in writing that the relevant financing facilities exist.

14.5.10 The sponsor should ensure that the Reporting Accountant’s terms of engagement follow conventional practice. See section 3.7 above (“Financial Content of the Listing Document – Guidance on Profit Forecast and Working Capital Statement, and Recommended Steps”).

14.5.11 It is also practice for the sponsor to review and comment on the listing applicant’s model and profit forecast and cash-flow memorandum as they are developed. Familiarity with the model (and, in particular, the bases and assumptions on which it has been prepared), and reviewing and commenting, is an important part of the sponsor’s overall financial due diligence.

14.5.12 The sponsor should always obtain a written confirmation from the listing applicant and its directors in support of the working capital statement in the form stipulated in Listing Rule 8.21A(1)(a).

14.6 Reporting Accountant Input to the Review Process

14.6.1 The Reporting Accountant’s input should normally be both (i) formal (see “Formal Process” above for technical reporting requirements) and (ii) where possible, discursive.

14.6.2 The sponsor should seek to arrange meeting(s) with the Reporting Accountant to discuss the listing applicant’s forecasts and projections, and the supportive profit forecast and cash-flow memorandum.

14.6.3 Although the detailed discussion items will vary depending on the circumstances and profile of the particular listing applicant, the discussion should normally encompass the questions contained in section 6 (“Forecasting”) of the schedule of Sample Questions For Reporting Accountants in Appendix II to Chapter 20 “Due Diligence Guidelines – Accountants”.

14.6.4 The sponsor will normally also want to confirm at as early a point as possible that the Reporting Accountant anticipates issuing its report(s) on the working capital statement and (where applicable) profit forecast in conventional form without unusual qualification or assumptions. See also section 7 (“Accountants’ report and comfort”) of the schedule of Sample Questions For Reporting Accountants in Appendix II to Chapter 20 “Due Diligence Guidelines – Accountants”.

14.6.5 As indicated above (see paragraphs 3.4.5 and 3.7.15), in addition to (and irrespective of) its report on any profit forecast, the Reporting Accountant’s finalised private report on working capital should be issued and obtained contemporaneously with the sponsor’s confirmation to the Stock Exchange.

14.6.6 As with accounting and audit interviews, the nature and degree of the Reporting Accountant’s participation in due diligence interviews will normally be governed by its terms of engagement consistent with prevailing industry practices. See sections 7 (“Accounting Review Process”) and 8 (“Audit Review Process”) above, and Chapter 20 “Due Diligence Guidelines – Accountants”.

14.6.7 Again, effective interaction with the Reporting Accountant is generally regarded as an important component of due diligence, and an area where the sponsor is significantly dependent upon the Reporting Accountant’s preparedness to embrace the process.

14.7 Published Assumptions Relative to Profit Forecasts

14.7.1 The listing applicant’s combined profit forecast and cash-flow memorandum should normally set out in detail the commercial and financial assumptions underlying the forecasts and projections. This is for essential clarity and informational purposes, to understand and record how the forecast has been arrived at. By their nature these assumptions will extend to matters such as sales and costs which are the core internal judgements salient to the forecast, and the essence of the forecast itself.

14.7.2 In contrast, the approach taken in the listing document has traditionally involved:

(a) A simple minimalist form of forecast; and

(b) Disclosure of assumptions which are necessary for investors to evaluate the achievability of the forecast (and which therefore effectively serve as risk warnings).

14.7.3 Accordingly, the essential commercial assumptions are not stated as assumptions (or qualifiers) in the listing document because (as noted) these are the core internal judgements which the directors are making within the forecast (and it is not appropriate to cast doubt on or disclaim them). (See section 3 above “Financial Content of the Listing Document – Rules on Core Content – Profit Forecasts”).

14.7.4 As a result, published assumptions have typically been restricted to key extrinsic risks such as:

(a) Business and economic climate (including inflation);

(b) Change of law and regulation (and regulatory policy etc);

(c) Tax rates, and tax policies;

(d) Exchange rates;

(e) Commodity prices (especially for mining, petroleum and other resources companies);

(f) Force majeure and natural disasters;

(g) Availability of financing facilities;

(h) Performance / default by contractual counterparties; and

(i) Key management, and availability of existing (and/or increased) staffing.

14.7.5 Although the approach to profit forecast disclosure in Hong Kong has (as stated) traditionally been minimalist, there are increasing instances where more extensive disclosure of detailed financial inputs and/or sensitivity disclosure has been included. Examples include (or might include):

(a) Real Estate Investment Trusts: where, in view of the nature of the business, it is common to provide detailed line item components of the forecast.

(b) Property companies: where profits can be significantly impacted by fair value adjustments from property revaluations.

(c) Companies with material derivatives: where again profits can be significantly impacted by fair value adjustments.

(d) Specific areas of doubt such as the outcome of a dispute or an insurance claim.

14.7.6 In cases where profits may be affected by non-cash items dependent on extrinsic factors outside the control of the listing applicant (e.g, revaluation of investment properties), the sponsor should consider if any relevant assumptions (or the reasonableness of such assumptions) can be substantiated from independent sources. (Using the same example of investment properties, the sponsor should consider if it is possible for the reasonableness of any estimations of rentals or other significant financial metrics to be assessed by the independent property valuer.) In cases where such third party validation is feasible, the sponsor should ensure that this work is appropriately provided for in the scope of third party engagements.

14.7.7 In many other cases it will not be feasible to obtain third party or other objective substantiation of material assumptions, often because they are dependent on factors which are inherently incapable of reliable prediction; for example, derivative valuations which are dependent on (and sensitive to changes in) the listing applicant’s own share price.

14.7.8 As a general matter, additional disclosure may be considered in appropriate cases where uncertainties exist stemming from definable causes (and which do not go to the essential reliability or overall integrity of the forecast or the listing applicant). There are examples to be found (for instance) of disclosures linked to risk factors (both specific and general).

14.7.9 In all cases, the sponsor should exercise care to ensure that the nature of any material assumptions (for example (i) anticipated changes in value of investment properties, or the assumed absence of any such change or (ii) dependencies of derivative values on interest rates or other relevant factors which are inherently incapable of reliable prediction) are clearly and accurately disclosed.

14.8 Profit Estimates

14.8.1 In the context of a listing document, a profit estimate is an estimate of profits or losses for a period which has ended, but for which the results have not yet been audited.

14.8.2 A profit estimate is treated as a forecast for technical purposes of the Listing Rules and due diligence considerations are equivalent (though, in practice, there is normally significantly greater inherent certainty for obvious reasons).

14.8.3 Because the reliability of an estimate is not dependent on future events, the published assumptions relevant to achievability of forecasts are not relevant to a profit estimate.

14.8.4 Reference should be made to Exchange Guidance Letter GL35-12.

14.9 Summary and Recommended Steps

14.9.1 The sponsor should always review and discuss the listing applicant’s combined profit forecast and cash-flow memorandum.

14.9.2 It should be discussed with the listing applicant’s management and the Reporting Accountant (see above “Sponsor’s Review Process” and “Reporting Accountant Input to the Review Process”).

14.9.3 In addition to (and irrespective of) the published report on any profit forecast, the Reporting Accountant should also be engaged to report privately with respect to the working capital statement.

14.9.4 The sponsor together with its legal advisers should ensure that the Reporting Accountant’s terms of engagement follow conventional practice (see above “Formal Process”).

14.9.5 The sponsor should consider the appropriate scope of bases and assumptions underlying the profit forecast for disclosure in the listing document (see above “Published Assumptions Relative to Profit Forecasts”).